What is Discount Rate?
The discount rate, as we said before this is, in general, the cost of capital. We’re going to discuss a little bit later that there might be exceptions to this. So more often than not, we can think of this as the cost of capital for companies that are operating just one country, or companies that have only one division, or manufacture only one specific product of service the cost of capital is a typical discount rate. Now, there’s a question again that we threw a couple times already at the end of the last session and at the beginning of this one. What happens if you operate in many different countries or you have many different divisions? Then there’s a question to be made here whether we need different discount rates for different countries and different divisions. And again we’ll deal with that a little bit later on, but for now, we can think of that discount rate as being the cost of capital. And whether it is the cap, the cost of capital or not what, what stands clear is that that discount rate is always going to be positively related to risk. And that basically means that the riskier the investment that we have or the riskier the company for which we’re evaluating this project, then the higher that discount rate is going to be, and everything else equal the lower the net price in value is going to be.
The idea of discounting, well we already discussed this. There’s two reasons for discounting, and it’s important that you keep both of them in mind. We typically think of discounting whenever you see a present value expression or a net present value expression, and let me open a quick parenthesis here. The only difference between a present value and a net present value is that initial cash flow, the CF 0 that you’re seeing in the expression. And remember, some people called it net simply because they take out, or that they actually include, the initial investment that you need to make in order to forecast the project. So, you know, if you were only discounting what you expect to get out of this project, then that typically is something that we call the present value of all the cash flows that we expect to get. But if we actually take into account the initial investment that we need to expect those cash flows, then many people would call that the net present value. At the end of the day, there’s not a whole lot of difference but because the tool is typically known as NPV or net present value, that’s the name that that we’re going to use. So press in value unit, press in value for our purposes is indistinguishable in terms that what we really care about is foreseeing all the money that needs to go out of the company and all the money that is expected to come into the company. But back now to the issue of discounting. Most people focus on discounting because of the passage of time. That is, the further away you get those dollars, then the higher the discount rate that you need to apply. And that is perfectly correct. But there’s one other thing that we mentioned before and you do need to keep into account that is a reason for discounting, and that is risk, right. Remember if you look at the expression once again of the NPV the higher excuse me the further away the cash flow, then the higher it’s going to be the discount rate, because the higher is the power at which we’re raising 1 plus DR 2, 3, 4 all the way to T. But also, the higher risk of the company, the higher the require return, and the higher is going to be the discount rate. So there’s two reasons, not just one, two reasons for discounting. One is because we are not getting all the cash flows at the same time. And two, because of risk matters. And the riskier the investment opportunity everything else equal, then the lower will be the NPV. So keep that in mind, because there are two, not just one the reason for discounting. As for the rule, the rule is somewhat straightforward. What are we doing when we discount? Well, we are basically bringing future dollars into current value. So if I discount, properly discount, adjusting by time and by risk a dollar that I expect to get a year from now, when I discount that I’m basically I’m expressing that dollar in today’s currency. And so now we can compare the money that we need to put down today with the present value of the money I expect to get in the future. So now instead of comparing dollars today and dollars a year from now, which would be like comparing apple and oranges, we are actually comparing apples and apples after the proper discounting. So after discounting all the cash flow, what we’re doing is expressing all the future cash flows in current and present value. And now when we actually aggregate all these numbers, then we say something very simple. Look, if the net inflows and outflows of cash out of this company is positive, then we are going to invest in the project. In other words, the net press in values project, it is positive, go for this project and if the net present value is negative, then do not go for, for this project. But you can only do that after properly adjusting all the expected cash flows by when are you going to get them and by the risk of expecting those cash flows in the future. But having done that, the rule is very simple. If you get a positive NPV, you should go ahead with the project. If you get a negative NPV you should not go ahead with this with this project.