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Expert knowledge Discount rate

In the context of a business valuation using the DCF method or the discounted earnings method, the discount rate is used to assign a present value to future income or cash flows.

Written by

Peter Schmitz

Published on

Tags

Taxes

Assessment Practices

Category

International tax law
TABLE OF CONTENT

Discount rate and cost of capital: definition, calculation, IDW requirements

What is the discount rate?

In the context of a business valuation using the DCF method or the discounted earnings method, the discount rate is used to assign a present value to future income or cash flows. The discount rate is used to calculate the present value of future payments, whereby future payments are discounted to the present value. Among other things, currency fluctuations, the current interest rate level, the risk of payments and expectations of future inflation are taken into account. In general, the higher the discount rate, the lower the present value of future payments and vice versa. This article looks at the underlying theoretical concepts and addresses the most important aspects of determining the cost of capital from a business valuation perspective.

Cost of capital as expected return

Equity costs include dividend payments and increases in the value of an equity investment, while borrowing costs include interest payments. However, the cost of capital is not the actual returns achieved in the past, but the expected returns on a capital investment, taking into account the agreed conditions and the opportunities and risks of the capital investment. The cost of capital as an expected return is well suited as a discount rate in the DCF valuation, as a valuation interest rate in impairment tests or as a decision criterion in profitability calculations.

Method for calculating the discount rate

The method used to determine the cost of capital as an expected return is based on portfolio theory, a subfield of capital market theory. Modern portfolio theory was founded by the work of Harry M. Markowitz (1952). It describes assumptions about the investment behavior of capital investors, in particular their risk aversion. In order to achieve an optimal risk/return ratio, it is recommended to diversify investments.

The Capital Asset Pricing Model (CAPM) made it possible to explain the expected return on securities by distinguishing between systematic and unsystematic risks. In valuation practice, the CAPM or the Tax-CAPM has established itself as the standard model for determining the cost of capital.

Requirements of the standard setters IDW / IASB

With the adoption of the standard on business valuation (IDW S1) in 2000, the IDW made the determination of the cost of capital based on the CAPM binding for the auditing profession. This was further specified by the revision of IDW S1 in 2008. In addition, the cost of capital has found its way into accounting standards and case law via the IASB requirements and the decisions of the Federal Court of Justice.

Cost of capital in business valuation

For the valuation of a company, the future financial payment surpluses must be discounted to the valuation dates using a suitable interest rate. The capitalization rate used corresponds to the expected return on an alternative use of capital that is adequate in comparison to the valuation object. This should be methodologically appropriate in terms of maturity, risk and taxation. Return flows to providers of equity require discounting at the cost of equity. Cash surpluses that are available to all providers of capital must be discounted using a total cost of capital. The WACC approach has proven to be the most practicable method.

Calculating the cost of equity in the CAPM

The cost of equity indicates the return that a company must provide to its equity providers in order to adequately remunerate their invested capital. The CAPM model uses the following formula to calculate the cost of equity:

Calculating the cost of equity in the CAPM

The risk-free interest rate represents the interest rate of a risk-free investment, the beta measure indicates how strongly the company's share prices react to fluctuations in the market as a whole, and the market interest rate is the expected amount of return that investors expect from investing in the market as a whole. With the SmartZebra Valuation Pro module, business valuers can determine all the parameters they need.

Return on equity and its interpretation

The return on equity shows how much profit a company generates in relation to the equity invested. A higher return on equity is generally better, but a low return on equity can also have positive reasons, such as long-term growth strategies.

Equity risk premium

The return on equity corresponds to the risk-free interest rate plus the equity risk premium, which is the product of the beta factors and the equity risk premium.

Peer Group

If no capital market data is available, the weighted beta factors of a comparison group or peer group can be used. These companies should be comparable with the company to be valued in terms of their systematic risk.

equity risk premium

The equity risk premium represents the difference between the expected return on a broad market equity portfolio and a risk-free investment. The IDW's FAUB recommends a range of 5.50% to 7.00% for the CAPM and 5.0% to 6.0% for the Tax-CAPM.

Calculate borrowing costs

The cost of debt is usually calculated as the sum of the risk-free interest rate and a risk premium for the lenders. The risk-free interest rate is determined in a similar way to the cost of equity. The credit spread is derived from the credit rating and the credit spreads of comparable listed bonds. Data on credit spreads is provided by the SmartZebra Credit Spreads Pro module:

Wrapping it up

The discount rate is a central component of business valuation and cost of capital determination. Careful calculation and interpretation of these rates are critical to the accuracy of valuations. smartZebra's tools and expertise can help make this process efficient and ensure compliance requirements are met.

FAQs

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