How to build up the discount rate
The equity discount rate represents the cost of equity capital invested in a business purchase, such as the buyer’s down payment. A key input into the Discounted Cash Flow business valuation method, the discount rate consists of two components:
The risk free rate of return is what you would expect from an investment that has no risk of default. Government backed securities, such as the 20 year US Treasury coupon bonds, are generally believed to be risk free. Hence, their yield is commonly used as the risk free rate in building up the discount rate.
Valuing a Business based on Cash Flow and Discount Rate
Equity risk premium elements
The key elements of the risk premium comprise:
Discount rate build up formula
Calculation of the equity discount rate thus uses the following formula:
where Rf is the risk free rate of return, Pe is the premium for equity investment, Ps is the premium for small company size, Pi is the industry specific risk premium, and Pc is the premium for risk associated with the firm itself.
Bulding up your discount rate
Here then is the typical procedure used to build up the equity discount rate for small business valuation:
In this example, the total equity discount rate is 35%.
Worksheets to calculate your discount rate
ValuAdder includes financial recasting worksheets to help you calculate the discount rate for debt free or leveraged company scenarios.
Business Valuation Tools