finance

Understanding Discount Rates in DCF: Impact on Investment Valuation

Understanding Discount Rates in Discounted Cash Flow (DCF) Models

The discount rate in a Discounted Cash Flow (DCF) model plays a crucial role in adjusting future cash flows to their present value. This adjustment is essential because money received today has a higher value than the same amount received in the future, a principle known as the time value of money.

In an unlevered DCF analysis, the discount rate is typically represented by the Weighted Average Cost of Capital (WACC). This metric signifies the expected return on investment, which is aligned with the investment's associated risk levels. The discount rate serves as a benchmark for the minimum return investors anticipate from an investment when compared to others bearing similar risks.

The Impact of Discount Rates

The relationship between discount rates and investment risk can be summarized as follows:

  • Higher Discount Rate: If the discount rate is elevated, it denotes a higher investment risk. Consequently, future cash flows are assessed as less valuable.

  • Lower Discount Rate: A reduced discount rate suggests lower risk, thereby increasing the valuation of future cash flows.

Investment Scenarios

Consider two potential investment opportunities:

  1. Investing in a Start-up (Higher Risk Investment)

    • A start-up promises a return of ₹1,00,000 after one year. Given the inherent risks associated with startups, an investor may seek a higher return expectation. Suppose we use a discount rate of 12%.

  2. Investing in a Fixed Deposit (Lower Risk Investment)

    • A fixed deposit (FD) from a reputable Indian bank also promises ₹1,00,000 after one year. Due to its secure nature, the applicable discount rate is relatively lower—let’s say 6%.

Present Value Calculation

To compute the present value (PV) of ₹1,00,000 for both scenarios, we employ the following formula:

[ PV = \frac{FV}{(1 + r)^n} ]

Where:

  • PV = Present Value
  • FV = Future Value (₹1,00,000)
  • r = Discount Rate (expressed as a decimal)
  • n = Number of years (1 year in this instance)

Present Value for the Start-up Investment (12% Discount Rate):

[ PV = \frac{1,00,000}{(1 + 0.12)^1} \approx \frac{1,00,000}{1.12} \approx ₹ 89,286 ]

Present Value for the Fixed Deposit (6% Discount Rate):

[ PV = \frac{1,00,000}{(1 + 0.06)^1} \approx \frac{1,00,000}{1.06} \approx ₹ 94,340 ]

Interpretation of Results

  • Start-up Investment: The present value of ₹1,00,000 from the start-up is approximately ₹89,286, reflecting the higher risk associated with the investment. The uncertainty leads to a reduced valuation of the future cash flow.

  • Fixed Deposit: The present value of ₹1,00,000 from the fixed deposit stands at around ₹94,340, indicating the lesser risk involved. The security offered by the FD results in a higher present value.

Key Takeaways

  • A higher discount rate (e.g., 12% for the start-up) diminishes the present value of future cash flows due to the amplified risk.
  • A lower discount rate (e.g., 6% for the FD) enhances the present value of future cash flows, attributing to the reduced risk.

This analysis underscores how the discount rate influences risk assessment and aids investors in determining which opportunity aligns with their risk appetite and expectations for returns.