Discount Rates and Capitalization Rates
Welcome to another discussion, New Jersey Forensic Accountant. Today we're gonna talk about discount rates and capitalization rates. This is something you often hear in finance when doing analysis valuations and many other situations. What is meant by discount or capitalization rates? Sometimes, people will refer to it as the Federal Reserve discount rate, the federal funds rate, expected rate of return, cost of capital, required rate of return or capitalization rate.
Now, many of these are derived or derivatives of a discount rate and, you know, especially a capitalization rate. But when you hear things like Federal Reserve discount rate, that really has to do with the Federal Reserve. That is the rate that a bank...that the Federal Reserve loans to banks, that's the rate they use for their loans. They're the lender of last resort. The fed funds rate though, that's what the Federal Reserve encourages banks to loan to each other and that's usually lower. Well, it is always lower than the Federal Reserve rate because the bank doesn't wanna get involved in asymmetric issues between the banks and stuff like that. Banks know other banks better. But that is gonna be a discussion for another day, but expected rate of return, cost the capital, required rate of return and capitalization rate, these are all...really are derivatives of discount rate and hopefully we can get a little better understanding of why and how. I'm gonna give you an example later on in this video of why. This video really discusses rates used to analyze businesses, cashflow or other financial decision making.
The definition of a discount rate is the rate of return or discount, discount future cash flows back to the present value, right? If you are gonna make an investment or look at an analysis in the future, you wanna be able to take that, what's gonna happen in the future and discount it back and you can make a decision whether it's profitable or not.
The great importance of the discount rate is not that it provides you with the correct answer for investment opportunity, but rather it provides you a framework under which you can analyze the investments and develop a much deeper understanding. And this is what we love to use this for. This is why we go through this analysis and many companies go through the analysis of looking at cashflows and discount rates and doing that because it makes you think really, really deep about that issue you're looking at. And it also gives you a way to determine if you hit your objective or not. And that's the real power of a discount rate or a capitalization rate.
Some people have what's called a personal discount rate, you know, and it operates the same as a business. For example, if someone offered you...to pay you $100 a year for 10 years or $853, what would you select? You know, the way to do it is if you have a personal discount rate, if it was 2%, well then you probably would take the 850. If it was 3% both of these come out to the same number. And that's basically what a company does or an investor should be doing. Or if you're buying a small business, you should be doing is saying, "Hey, if I buy this investment, what am I gonna expect to earn from it?" And then you have to develop a discount rate.
The big question here is how do you develop a discount? This is the real complexity of this whole video here is how do you get a discount rate? But generally, it's not that hard, especially if you're looking at a company. If you have a company, the discount rate is what the company is required to pay investors to invest in a business, right? Because you don't wanna destroy value, but it makes sense. Think about it. What's a business' discount rate? Well, let's say you need to pay investors 15% to make an investment in your business, right? If you wanna borrow $100 from your friend, he says, "Well, I want a 15% return." And you say, "Why?" "Well, I can earn 3% if I invest in a T-bill, I can earn 8% if I invest in the stock market. Your company is more risky. I want 15%." There you have your discount rate, it's 15% right? And if you apply that to the cashflows in the future, that's what you should pay for the business.
Now, sometimes companies will use what's called a buildup method in order to find your discount rate. The buildup method basically has...it's composed of four components: safe rate, equity risk premium, size premium and specific premium. And in this example here, you could see the safe rate is basically what is the safest rate you can have? Well, it's a 10-year T-bill, right? The equity risk premium is basically what you earn in the market. And a size premium is the bigger company, less riskier it is for obvious reasons, right? A big company has better management. They have access to loans and stuff like that. They have usually an established marketplace. That's how they got big in the first place. And then specific company risks. Some companies are more risky than others, right? Restaurant's extremely risky, right? There's lots of stuff that you will apply this to. Now when you add all these up, you get what's called a discount rate. And here's your number that when you look at an investment or you look at evaluation, you're gonna use for this specific company because you built up a discount rate. And this is assuming a growth rate here of 3%. You're assuming that the revenues or cashflow is gonna grow 3% every year. And here's where it gets really interesting because once a company has a discount rate, it's very easy to get what's called capitalization rate. You just basically subtract the discount rate from the growth rate. Here, it's 14.05%, right? So now I have a cap rate. And remember I said a lot of these rates are derived from the discount rate. Once you get that, you can get a cap rate. Now, I'm gonna show you some stuff here that you don't read in textbooks and most professors don't go in, even though it kind of ties this whole concept of discount rate and capitalization rate together. And what I'm gonna do is go through a spreadsheet that just kind of gives you a good background and ties together in a way that simplifies it.
Okay, so here we have the buildup method that I just showed you. Here's the growth rate, right? We have a discount rate of 17%. And what we've done is we've done a forecast of cashflows for a business. Here, we're gonna value business based on its cashflows from 2020 to 2024. Okay, these are in millions and what we're assuming here is that this is the initial cashflow we're going to get is $425 million and that's gonna grow at 3% a year into for the next 5 years at least. And from that, we can then figure out what our cash flow is, right? Once we have our cashflow, we can apply the discount rate. We're gonna say EBIT earnings before interest in tax is 15% of sales, which is this number here, in 2020 it would be $63.8 million. Now, unfortunately we have taxes which would be 21% of EBIT, right, is 13.4 in investment. Now, every business makes investment. Just like when you have a house, you have to make investments in the house or an apartment, right? You have to paint it, you have to fix the bathroom. When you have a business, you gotta buy new equipment, you gotta fix the roof, you gotta make investments and you have to account for that. You can't assume you're not gonna spend money on investments. So here we have $17 million of investments we're gonna spend in 2020 and you can look, you know, it's gonna go up a little bit every year. And now we have networking capital. This is the increase in networking capital because just like you have money in your bank, you have zero hopefully not in your checking account. You need money to operate on. And when you have a business, we need to have cash in the bank and things like that. Or we have receivables, it's sales we made, but they're not liquid. So this is increase that we need in networking capital every year, $6.4 million, $6.6 million just to run the business, right? We need to have a little cushion and enter to make payroll and stuff like that.
Now once you have these numbers here, okay, we can then figure out what our net cashflow is. In 2020, we'd make $27 million in net cashflow, okay? That's what we'd expect. And this number is increasing every year, right? So now that we know our cashflows, we have a problem here in 2024 because this business, we're not projecting it's gonna go out of business. It's like buying Ford Motor Company in 1930. If you bought Ford Motor Company 1930 well here we are 2020, it's still here. So you can't just account for four years of cashflow, right? You have all those other years. And we do have a finance technique that's called the perpetuity or the Gordon growth method that calculates what we're gonna earn in this business based on our assumptions from 2024 through infinity. And remember a dollar in 30 or 40 years is worth maybe a 1 cent now. So those cashflows that go way out 50, 60, 70 year, they're basically worth nothing now. But this method takes all that into consideration so you can do your calculations.
And here's the formula, okay? Basically we're gonna take our growth rate, you know, and put...you know, it's 1.03, and we're gonna divide it by our discount rate minus our growth rate, right? And we're gonna multiply this by our cashflow that we have here, which is $30.4 million. And when you do this formula, this kind of calculates what you're gonna get in those out years. We're gonna get about a net present value as of December 31st, 2024 of $222.7 million. That's what all those cashflows are worth. Now, we can actually do our analysis because I have all my cashflows. I have cashflows here in to 2020, $27 million, $27.8 million, $28.6 million, $29.5 million. And when I add these two, I have a $253.1 million in that fifth year. And I just simply take those and I do a discount on them. Now, we know how to do a discount or you should know how to do a discount. It's basically the cashflow, right? And then you're gonna divide it by the discount rate multiplied by an exponent. Like this is year one. So it's basically gonna be the $27 million divided by my discount rate, 1.1705, and I'm gonna take that to my exponent of it's year 1, right? I'm gonna do it for year two here. This is year three, year four, year five, basically using the same exact numbers. And when I add all those up, it says, okay, you should be paying, if you wanna earn 17% from this, you shouldn't pay $192 million, okay? And if we don't earn [inaudible 00:12:14], let's say we only earn 16%, well then we're losing money because right, it's worth $192 million here and our...we're not getting our return we expect, 17%, we're getting less, or hopefully we get more, 20% this will be higher.
So, you know, this tells you how much you should pay for the business based on all these assumptions. Now, here's the interesting part, which most people don't do. Okay, now, the capitalization rate we talked about, you derive it from the discount rate. And all I have to do, and you notice these numbers are the same, $192.1 million, all you have to do is take this cashflow here and divide it by your cap rate, right? Which is just 17 minus 3% and you get the exact same number. So think about that. I mean, you should understand, I mean, why that happens because we were assuming a constant growth. If you don't, then that's not gonna happen. But the great thing here is that you could just get a cap rate and it's gonna give you a good answer once...it's gonna give you information you can use. You don't have to go through all this work that I did, right? And remember, these spreadsheets in real life are, you know, 15, 20, 100 pages long, the analysis for a big company. You know, this is compressed, but basically the same exact concept.
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