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Discount Rate

Definition

The interest rate that is used in the Discounted Cash Flow business valuation method to determine what the expected business income stream is worth in present day dollars.
What It Means

The discount rate represents the required rate of return to make a business acquisition worth while. The idea is to look at a business purchase as an investment decision. Given that point of view, the business purchase investment must be compared against other, possibly safer, alternatives.

For example, if you could invest in the US Government bonds at 5% annual return, then the business must produce returns that are higher, in order to account for the risks of owning and operating the business.

The equity discount rate can be calculated by using one or more of the cost of capital models.

For example, the discount rate used in small business valuation can be built up by the following procedure:

Take the long-term US Government Treasury Coupon Bond yield as the risk-free return basis.

Add a premium to account for the risk of equity investment.

Add a premium to compensate for the risk of investing in a small company.

Add a premium which reflects the risk specific to the industry in which the small business operates.

Add a premium to offset the time and effort required to run the small business.

If the business purchase is financed by both equity and debt, the discount rate can be computed as a weighted average cost of total acquisition capital.

How to build up the discount rate

The equity discount rate represents the cost of equity capital invested in a business purchase, such as the buyer’s down payment. A key input into the Discounted Cash Flow business valuation method, the discount rate consists of two components:

Risk free rate of return.
Premium for risk assumed in owning and operating a business.
The risk free rate of return is what you would expect from an investment that has no risk of default. Government backed securities, such as the 20 year US Treasury coupon bonds, are generally believed to be risk free. Hence, their yield is commonly used as the risk free rate in building up the discount rate.

Equity risk premium elements

The key elements of the risk premium comprise:

Risk premium to account for equity investment. This risk reflects the uncertainty as to the amount and timing of dividend distributions and gains realized from public company stock appreciation.
Risk premium which accounts for the company size. Generally, smaller company size is associated with higher investment risk. Hence small company investors demand higher returns.
Risk premium specific to the industry in which the business operates. High risk industries would result in higher industry risk premia.
Company specific risk premium which accounts for the unique attributes of the business itself. Business risk factors that lead to higher premium values include unstable earnings, high leverage, customer or product concentration.

Discount rate build up formula

Calculation of the equity discount rate thus uses the following formula:

D = Rf + Pe + Ps + Pi + Pc
where
Rf is the risk free rate of return,
Pe is the premium for equity investment,
Ps is the premium for small company size,
Pi is the industry specific risk premium,
Pc is the premium for risk associated with the firm itself.

Bulding up your discount rate

Here then is the typical procedure used to build up the equity discount rate for small business valuation:

Start with a risk-free return, e.g. the long-term US Treasury bond yield at 3% annually.

Add risk premium for publicly traded equity investment, e.g. 7%.

Add a size premium for investing in a small privately owned
business, e.g. 10%.

Add a premium for the industry the business operates in, e.g. 5%.

Add a premium to account for the risk of investing in the subject business, e.g. 10%. This represents the company specific risk premium or CSRP.

In this example, the total equity discount rate is 35%.
Worksheets to calculate your discount rate

ValuAdder includes financial recasting worksheets to help you calculate the discount rate for debt free or leveraged company scenarios.

From ..
//www.valuadder.com/valuationguide/discount-rate-buildup.html

Create Date : 10 กรกฎาคม 2558

Last Update : 10 กรกฎาคม 2558 7:51:41 น.

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