How to Calculate the Discount Factor for a Company
The discount factor of a company is the rate of return that a capital expenditure project must meet to be accepted. It is used to calculate the net present value of future cash flows from a project and to compare this amount to the initial investment. The discount factor used in this calculation is the company's weighted average cost of capital.
Calculation of Weighted Average Cost of Capital
A company's weighted average cost of capital is made up of the firm's interest cost of debt and the shareholders' required return on equity capital. Consider the following data from the balance sheet of the Hasty Rabbit Corporation:
- Total amount of long-term debt: $200,000
- Interest on long-term debt: 5 percent
- Total amount of equity capital: $300,000
- Stockholders' required return on capital: 11 percent
- Percentage of long-term debt: $200,000/($200,000 + $300,000) = 40 percent
- Percentage of equity capital: $300,000/($200,000 + $300,000) = 60 percent
Weighted average cost of capital = 40 percent x 5 percent + 60 percent x 11 percent = 8.6 percent
The company will use 8.6 percent as its discount factor in the net present value method to evaluate projects.
Example of Net Present Value Method
The Hasty Rabbit Corporation makes lightweight sneakers for rabbits. The company has had amazing success with its latest sneaker design, Swifty Feet, and is considering expanding the production capacity. The expansion will increase production volume by 1,300 pairs per year and will cost $125,000.
The company's accountants have calculated that the additional cash flows from the expansion will be as follows:
- Year 1: $40,000
- Year 2: $42,000
- Year 3: $43,000
- Year 4: $44,000
- Year 5: $45,000
Present value of expected cash flows: $167,438 at 8.6 percent.
Net present value = $167,438 - $125,000 = $42,438.
The accountants did not make any projections beyond five years, because sneaker designs are fashion fads that can change or disappear quickly. Because the present value of the expected cash flows exceeds the original investment by $42,438, the chief financial officer of Hasty Rabbit will recommend expanding the production line of Swifty Feet.
Adjustments to the Discount Factor
Generally, higher discount factors will decrease the net present value of a project. The discount factor should be adjusted higher for projects with riskier and less certain cash flows. Long-term projects should use a higher discount rate than short-term projects.
Each company will have its own weighted average cost of capital, or discount factor, depending on the proportion of debt and equity on its balance sheet. In addition, shareholders can demand that projects have higher returns if they perceive that the projects are riskier.
References
Tips
- To determine present value for the future payments, multiply the amount owed by the discount factor. For example, if the company was owed $100,000 over the three years in our example, then the net present value would be $100,000 x 0.8357, or $83,570.
Writer Bio
James Woodruff has been a management consultant to more than 1,000 small businesses. As a senior management consultant and owner, he used his technical expertise to conduct an analysis of a company's operational, financial and business management issues. James has been writing business and finance related topics for work.chron, bizfluent.com, smallbusiness.chron.com and e-commerce websites since 2007. He graduated from Georgia Tech with a Bachelor of Mechanical Engineering and received an MBA from Columbia University.