The interest rate that is used in the Discounted Cash Flow business valuation method to determine what the expected business income stream is worth in present day dollars.
What It Means
The discount rate represents the required rate of return to make a business acquisition worth while. The idea is to look at a business purchase as an investment decision. Given that point of view, the business purchase investment must be compared against other, possibly safer, alternatives.
For example, if you could invest in the US Government bonds at 5% annual return, then the business must produce returns that are higher, in order to account for the risks of owning and operating the business.
The equity discount rate can be calculated by using one or more of the cost of capital models.
For example, the discount rate used in small business valuation can be built up by the following procedure:
- Take the long-term US Government Treasury Coupon Bond yield as the risk-free return basis.
- Add a premium to account for the risk of equity investment.
- Add a premium to compensate for the risk of investing in a small company.
- Add a premium which reflects the risk specific to the industry in which the small business operates.
- Add a premium to offset the time and effort required to run the small business. This is known as the company specific risk premium or CSRP.
If the business purchase is financed by both equity and debt, the discount rate can be computed as a weighted average cost of total acquisition capital.