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Concepts of Determination of Discounting Rate

Introduction

Discounting rate is rate of the investors expected return for their finances. A company can get its finance from two sources; debt and equity. Debt financing is the finance that is borrowed from parties’ other than the owners of the business (Forrest A.G., 1990). Equity finance is the capital that is derived from the owners of the company i.e. shareholders. A finance manager has the obligation of determining the most appropriate source of finance or the blend that will maximize the shareholder’s wealth.

Determination of discounting rate

Forrest A.G. (1990, p.22) says, “When determining the discounting rate, the manager has to consider the cost of capital of each component source of finance.” The cost of equity and debt must be determined because the two will determine the overall cost of capital. Finance managers have to consider to what extent the company should be indebted as this will influence the liquidity of the company. High leverage level is risky for the company as the payment of interest may prove costly in the long run.

Risk factors also face the managers before settling on a discounting rate. When the projects undertaken by the company are those of high risk, the discounting rate will be high as the providers of capital will require more return to shield the risk of payment default. a risk return trade off must therefore be considered to help choose the best discount rate.

Forrest A.G. (1990) suggests that the government rates are vital prior to the determination of the discounting rate. Government rates are taken to be the risk free rate as the risk of default is low. Before a finance manager sets the rate of discounting its capital, the government rate will act as the floor rate of determining the returns for the debt finance. The industry rate is also an issue for consideration. This is because the performance of the business is pegged on the industry.

Moreover, the proportion for the different finance sources will determine the rates of discounts. Models like the weighted average cost of capital depend on the percentages of the different finance sources. Forrest A.G. (1990) adds that, “The finance manager will thus have to determine what proportion of the company’s capital to be financed by the various capital sources.”

A finance manager is equipped with different models for the determination of the discounting rate. The first model that a finance manager can employ in the setting of the rate is the capital asset pricing model. This model equates discounting rate to the sum of the risk free rate and the risk premium. In this method, the risk free rate is set according to the government lending rates i.e. the government bills and bonds. The risk premium is given by the difference between the expected return and the risk free rate.

Determination of discounting rate

Beta factor is determined by the gradient of the market security line. The y-intercept of the security market line will represent the risk free rate. As the risk market return increases the risk premium rises thereby increasing the required return rate. CAPM is used to determine cost of equity alone.

Closely linked to the CAPM model is the arbitrage pricing technique. This technique is an extension of the CAPM model as the only difference is that it incorporates many beta factors for the different risk premiums.

Another model that can be used in the determination of the discounting rate is the weighted average cost of capital. This model takes into account the proportion of the various sources and the rate of each source. Since debt finance is tax deductible, the rate is summed is the after tax cost of capital

Determination of discounting rate

Where S is the value of equity

D is the debt finance

tc is the tax rate.

This model has the advantage that it considers all sources of finance in determination of the discounting rate. The drawback of WACC method is the fact that it considers even the funds that were used in the past to calculate the rate. This has therefore led to the adoption of the marginal cost of capital by some companies, In marginal cost of capital, only cost for new funds is used in calculating the rate.

Conclusion

In my own opinion, the weighted cost of capital is the best model for the determination of the discounting rate. This is because it considers both debt and equity sources. CAPM is used only to determine the cost of equity finance thereby not a complete method. Again, the method is better because the cost of new sources of funds will depend on the leverage levels that exist.

Reference

Forrest A.G. (1990). Which Fair-Market-Value Should You Use? , Journal of Petroleum Technology, SPE Paper No. 20276.

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