okay excellent in this lesson we’ll talk
about discount rates we said that to perform a capital budgeting exercise we
must discount future cash flows and obtain their present value however we
still must cover a subtle topic which is the discount rate that should be used
for this calculation well that’s up to the person carrying out the analysis but
a few alternatives are typically used in different scenarios depending on the
project we are valuing and the way it will be financed our discount rate could
be the firm’s cost of debt the firm’s cost of equity its weighted average cost
of capital or a hurdle rate chosen by management cost of debt this is the
average interest rate the company pays on its borrowings it makes sense to use
the cost of debt as a discounting rate if the entire project is financed with
debt in this case this is the cost the company sustains to finance the project
hence when we use the cost of debt as a discounting rate we’ll be able to
compare the investment required now and the present value of the cash flows the
project will generate an alternative discount rate is the company’s cost of
equity there are many ways to calculate a company’s cost of equity in this
course we’ll apply the one used by investment bankers it is called the
capital asset pricing model also known as cap M the model was introduced in the
1960s but remains relevant to this day and age the capital asset pricing model
suggests a company’s cost of equity is equal to the risk-free rate plus beta
multiplied by the market risk premium the risk-free rate in an economy is the
rate of return that an investor would expect from a financial security that
contains zero default risk the investor buys the security man can be certain he
will be repaid on time and in full in the complicated world of today very few
securities can be considered risk-free but most practitioners use the yield of
a ten-year government bond to approximate this measure the governments
of developed countries have a saw reputation and can be trusted in a
10-year time frame the rationale behind using a 10 year and not a three month
bond is that the valuation of the firm is a multi-year exercise
hence the risk-free rate used shouldn’t reflect a period as short as three
months the next component in the calculation is beta this is a
statistical measure for those of you who love statistics and quantify Nantz beta
can be calculated with the following formula and it is basically used to show
how a financial security behaves regarding the rest of the market that is
why we are dividing its covariance with the rest of the market by the markets
variance if this is confusing don’t worry
many financial providers calculate a company’s beta for you let’s open P and
G’s Yahoo Finance profile as promised you can’t immediately see the company’s
beta here it is almost 0.5 which usually is considered a conservative stock a
beta that is less than 1 indicates the stock is less volatile than the market a
beta of 1 shows the stock is as volatile as the market if the market gains 1% it
will also gain 1% if the market loses 5% it will lose 5% stocks that have a beta
higher than 1 are considered aggressive and are more volatile than the market if
the market grows 2% the respective stock will probably earn 2 point 5 or 3% and
so on you get it right a company’s beta will typically have a
value ranging between 0 and 2 the next component in cap M is market risk
premium theoretically it is given by the average expected return of the market
minus the risk-free rate academic research has shown the average market
risk premium rate varies between 4.5% and 5.5% and most practitioners use 5%
in their cost of equity calculations so we will have the following the cost of
equity in a company is given by the risk-free rate in the economy where it
operates plus the company’s beta multiplied
by 5% cost of equity is not that difficult to calculate right you can
find the yield of a 10-year US bond in Google then we saw that accompanies beta
is available in platforms like yahoo finance and Bloomberg and finally we
multiply by a constant 5% easy right if we take a careful look at Cap M it makes
sense a financial securities return should be composed of two parts first
the risk free rate of return has a minimum compensating the investor for
the time value of money and a second component compensating the investor for
the additional risk for holding a security that is not risk-free the risk
is measured by comparing the stock to the rest of the market and the result is
that the riskier the stock the higher its expected return should be brilliant
isn’t it so this is how we can calculate a company’s cost of equity the cap M
model is one of the most widely accepted academic papers on this topic we can use
the cost of equity as a discounting factor for projects financed entirely
with our own funds with equity this is an assumption that no debt will be used
to finance the project I’m sure you’ll agree that in practice projects are not
financed with just equity or debt in 90% of the cases we’ll use a mixture of both
stay tuned and we’ll discuss what to do in these situations in our next lesson