What is: The Discount Rate is the cost of capital used in a return analysis. It can be calculated in several different ways, because it is not an exact science. One of the most well-known forms is the WACC of English Weighted Average Capital Cost (Weighted Average Cost of Capital). This rate indicates the level of minimum attractiveness of the investment, ie it is the return you would expect to have on other investments more secure than the current one.
How to: Although there are several theoretical discussions about the discount rate, in this post we will try to simplify and demonstrate a simple way to perform the calculation in a few steps. The WACC formula follows below:
a) Cost of Equity Costing
The cost of equity is a subjective measure. This is the opportunity cost of the shareholders because they are investing in the project in question and not in more or less profitable assets.
The first step is to raise different sources of income with viable investments and their respective returns either per month or per year, as shown below:
Then, the cost of equity must be calculated using the risk premium between the assets calculated in the previous table and the return of the lowest risk asset in the market. Generally, the Long-Term Interest Rate (TJLP) as risk-free asset.
Another important variable is the Beta which is the expected growth rate of your company compared to the market and the expected return, as shown below:
In the example above, it was considered that the analyzed company would grow 1,5x more than its market segment, through its projections.
The formula for calculating cost of equity is: Ke = Rf + Beta * [E (Rm) - Rf].
b) Making the Weighted Average
From the formula shown at the beginning of the post, we can see that E / (D + E) and D / (D + E) represent the proportion of company capital financed by shareholders and by third parties, respectively. To design them, you should simply think about how much of the initial investment and working capital need needed for the company will be financed by equity (shareholders and retained earnings) and how much will be financed by debt.
The Kd (Cost of Debt) is also easy to calculate because it is not subjective. The cost of a debt will always be the interest rate intrinsic to it. Just think of the average interest that you intend to pay on the debt that will be applied in the company.
Since you have already calculated the Cost of Own Capital previously, the last and simplest step is to distribute how much capital you will get from which source and thus actually do the weighted average:
This post has clarified how you can calculate the discount rate or WACC? LUZ develops management tools for companies including a worksheet Valuation which helps you better understand your discount rate!