Discount rate

The come out mappingd to bank bank discount future funds flows to their present honours is a key variable star of this process. A firms weight down bonnie damage of majuscule (after tax) is often habitd, further many tribe believe that it is appropriate to delectation higher discount appreciates to go down for lay on the line or former(a) parts. A variable discount set out with higher prizes utilize to hard cash flows occurring further along the succession span might be used to reflect the yield carousal premium for long-term debt. round other approach to choosing the discount rate factor is to decide the rate which the upper-case letter needed for the project could return if invested in an alternative venture.If, for example, the capital compulsory for Project A pile enlighten five percent elsewhere, use this discount rate in the NPV weighing to allow a purpose proportion to be made among Project A and the alternative. connect to this concept is to use the firms Reinvestment Rate. Reinvestment rate can be defined as the rate of return for the firms investments on average. When analyzing projects in a capital restrain environment, it whitethorn be appropriate to use the reinvestment rate rather than the firms charge average speak to of capital as the discount factor.It reflects opportunity cost of investment, rather than the possibly lower cost of capital. An NPV calculated utilise variable discount rates (if they atomic number 18 cognise for the duration of the investment) better reflects the square situation than one calculated from a constant discount rate for the entire investment duration. Refer to the tutorial article written by Samuel Baker3 for more detailed relationship betwixt the NPV value and the discount rate. For some professional investors, their investment funds are committed to target a specified rate of return.In much(prenominal) cases, that rate of return should be selected as the discount rate for the NPV calculation. In this way, a direct comparison can be made surrounded by the profitability of the project and the desire rate of return. To some extent, the selection of the discount rate is dependent on the use to which it will be put. If the intent is simply to determine whether a project will add value to the company, using the firms weighted average cost of capital may be appropriate.If trying to decide betwixt alternative investments in order to increase the value of the firm, the corporate reinvestment rate would probably be a etter choice. utilize variable rates all over time, or discounting guaranteed cash flows differently from at risk cash flows may be a superior methodology, but is seldom used in practice. Using the discount rate to coiffure for risk is often tricky to do in practice (especially internationally), and is touchy to do well. An alternative to using discount factor to adjust for risk is to explicitly correct the cash flows for the risk elemen ts using rNPV or a similar method, then discount at the firms rate.Discount rateThe rate used to discount future cash flows to their present values is a key variable of this process. A firms weighted average cost of capital (after tax) is often used, but many people believe that it is appropriate to use higher discount rates to adjust for risk or other factors. A variable discount rate with higher rates applied to cash flows occurring further along the time span might be used to reflect the yield curve premium for long-term debt. Another approach to choosing the discount rate factor is to decide the rate which the capital needed for the project could return if invested in an alternative venture.If, for example, the capital required for Project A can earn five percent elsewhere, use this discount rate in the NPV calculation to allow a direct comparison to be made between Project A and the alternative. Related to this concept is to use the firms Reinvestment Rate. Reinvestment rate ca n be defined as the rate of return for the firms investments on average. When analyzing projects in a capital constrained environment, it may be appropriate to use the reinvestment rate rather than the firms weighted average cost of capital as the discount factor.It reflects opportunity cost of investment, rather than the possibly lower cost of capital. An NPV calculated using variable discount rates (if they are known for the duration of the investment) better reflects the real situation than one calculated from a constant discount rate for the entire investment duration. Refer to the tutorial article written by Samuel Baker3 for more detailed relationship between the NPV value and the discount rate. For some professional investors, their investment funds are committed to target a specified rate of return.In such cases, that rate of return should be selected as the discount rate for the NPV calculation. In this way, a direct comparison can be made between the profitability of the p roject and the desired rate of return. To some extent, the selection of the discount rate is dependent on the use to which it will be put. If the intent is simply to determine whether a project will add value to the company, using the firms weighted average cost of capital may be appropriate.If trying to decide between alternative investments in order to maximize the value of the firm, the corporate reinvestment rate would probably be a etter choice. Using variable rates over time, or discounting guaranteed cash flows differently from at risk cash flows may be a superior methodology, but is seldom used in practice. Using the discount rate to adjust for risk is often difficult to do in practice (especially internationally), and is difficult to do well. An alternative to using discount factor to adjust for risk is to explicitly correct the cash flows for the risk elements using rNPV or a similar method, then discount at the firms rate.