Demystifying discount rates used in business valuations

Valuation professionals often use discounted cash flow (DCF) techniques to determine the value of a business or estimate economic losses. A critical input in a DCF model is the cost of capital — the rate that’s used to discount future earnings to today’s dollars. Modest changes in this rate can have a major impact on the expert’s conclusion, so it’s important to get it right.

Financing options

The cost of capital represents the expected rate of return that the market requires to attract funds to a particular investment. It’s based on the perceived risk of the investment. All else equal, as risk increases, the discount rate rises, and the value of the business or investment falls (and vice versa).

The cost of capital depends in part on whether the business is financed with 100% equity or a combination of equity and debt. In most cases, debt financing costs less than equity capital. Why? Debt holders receive regular economic benefits (principal and interest payments). But equity investors receive dividends only at management’s discretion, and they must wait until a sale to receive any capital appreciation, making their returns inherently less certain and thus the cost of equity higher.

Estimating the cost of equity

Several market-based components can be used to estimate the cost of equity. These typically include:

• A risk-free rate, based on U.S. Treasury securities,
• A market risk premium, based on historical returns for a stock index over the risk-free rate, and
• A company-specific risk premium, based on the subject company’s financial performance, industry and other attributes.

The cost of equity is used as the cost of capital when the subject company is financed entirely with equity or when the valuation expert discounts earnings available only to equity investors.

Calculating the WACC

When discounting the earnings available to both equity investors and creditors, valuators typically use a weighted average cost of capital (WACC). This rate incorporates the costs of both equity and debt financing, based on an assumed capital structure.

The cost of debt is generally derived from market-based borrowing rates available to the subject company, taking into account credit risk, collateral and prevailing lending conditions. As leverage increases, creditors typically demand higher interest rates to compensate for incremental risk. Interest expense is generally tax-deductible, which reduces the effective cost of debt. But valuators must consider current limitations on interest deductibility, particularly for larger companies subject to earnings-based caps under current tax law.

Selecting the appropriate capital structure

When using WACC as the discount rate, a valuator can choose various capital structures. What’s appropriate depends on the characteristics of the company and the applicable valuation standard.

For example, an expert might apply the subject company’s historical or expected percentages of debt and equity capital when valuing a business interest that lacks control over financing decisions. Alternatively, an expert might choose an industry average capital structure when calculating lost profits or valuing a controlling interest in the business.

What’s appropriate for your situation?

The cost of capital is a critical input in DCF models. The appropriate rate is determined on a case-by-case basis, depending on the facts and circumstances. Contact us for more information on developing and supporting cost of capital assumptions in today’s uncertain marketplace.

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