5. Choosing the Right Discount Rate
The discount rate helps you account for risk in your models. But how do I decide what's right the discount rate for an specific investment? Find out in this lesson.
Choosing the right discount rate
- The PV of an investment can be very sensitive to the discount rate
- For some organisations, one consistent discount rate is set in stone
- In these cases, all projects are valued with the same discount rate, regardless of the risk level
An alternative way of viewing the discount rate
- Try view the discount rate as the opportunity cost of capital
- This is the expected rate of return demanded by investors, subject to the same risks as the project
- Always ask experienced investors for their discount rate assumption when investing in new sectors
SHIFT + →: Select next cell
ALT + A , W, T: Create data table
As we saw on the previous lesson, the present value of our future cash flows, and hence our decisions, are very sensitive to the discount rate that we choose.
For our previous wind farm investment, let's run a sensitivity analysis on the discount rate, and see how it affects our valuation.
So to run a sensitivity analysis, I'll use a one row data table, and in this cell I'll enter the output value, which is going to be my present value of cash flows.
I'll then select this cell and include my array of input values for the discount rate, and then I'll press Alt + A W T for a data table, and the row input cell will be the discount rate.
And when I run this table, you can see that we get answers that vary from $5.27 million right down to $4.2 million.
So which is the right discount rate to use? In many companies, the discount rate or hurdle rate is actually set in stone, so there’s no decision for you to make.
In these companies, regardless of the project, a certain rate is always used to evaluate investments.
However, as I mentioned in previous lessons, the discount rate should vary according to the riskiness of an individual project.
Unless all the projects within the company have the exact same level of risk, then a constant discount rate doesn't make a lot of sense.
A better explanation and way of understanding the discount rate is to view it as the opportunity cost of capital.
The opportunity cost of capital is the expected rate of return demanded by investors, subject to the same risks as this project.
So in the case of our wind farm project, we could simply do some research, or ask other wind farm investors what rate of return they would typically expect on a project such as this.
We could then adopt this rate of return as our own discount rate.
Obviously the more experience you have buying wind farms, the better you will be at choosing the correct discount rate.
This is why it’s important to stay within your circle of competence.
In future courses, we'll examine some advanced models such as the capital asset pricing model, to determine discount rates for companies.
But for now, we'll assume the best way to calculate a discount rate is to simply ask experienced investors for their hurdle rate on a similar wind farm project.
In the next lesson, I'll introduce you to the concept of net present value and show you how to discount cash flows that do not occur annually.