![]() ![]() ![]() Instead of investing in new capital expenditures, a company could also choose to pay down debt or buy back stock with that same capital.įor example, if a company has debt outstanding at 7%, any new investments would have to earn a rate substantially above that figure to justify the risk versus the assured savings the company would get from reducing its interest burden. Those opportunity costs aren't just in the operations side of the business. Every decision must be considered not just in absolute return on investment terms but also what other possibilities the company is giving up to choose this particular route. #DISCOUNT RATE IT UPGRADE#If it builds a new factory, for example, that capital can't be used to expand its warehouses, open a distribution center in a new market, or upgrade machinery at existing plants. Opportunity CostĪnother way to think about discount rates is in terms of what a company foregoes to make a certain investment. In addition, the interest on debt is often discounted by the corporate tax rate if that interest is tax-deductible. If a company has issued preferred stock, it is included along with the equity and debt components of the blend as well. If a company has 75% equity and 25% debt, for example, then the equity cost of capital would represent 75% of the WACC with the debt making up the other 25%. The blend is based on the company's capital structure. It is calculated, most simply, by entering the blended price of a company's debt and equity. The weighted average cost of capital, or WACC, is a commonly-used formula for determining the rate at which a company has to pay to access funds. Others may base a discount rate on their cost of equity, cost of debt, weighted average cost of capital (WACC) or other such metrics. Some companies may use a discount rate equal to their hurdle rate. ![]() There is no one discount rate that universally applies. A lower discount rate, by contrast, signifies that the investor or management team sees fewer potential problems on the horizon. What a high discount rate signifies is that an investor or analyst is forecasting a higher level of risk in the future, and thus requires more expected return from the investment to compensate. Higher or lower isn't necessarily better than the other. Lower Discount Rateĭiscount rates aren't like scores in a sporting event. If a project has a positive expected value after accounting for the time value of money at a given discount rate, management may be encouraged to proceed with the investment. The general principle is that a company looks at the future expected cash flows that a project will generate and then discounts them by a set interest rate or required rate of return to see what the value of the project is in today's dollars. Ipopba/iStock via Getty Images How The Discount Rate Worksīroadly speaking, a discount rate is an internal metric that investors or management teams use to measure whether a potential investment will generate a sufficient return. ![]()
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