Discount or Capitalization Rates

A discount or capitalization rate is used to determine the present value of the expected returns of a business. The discount rate and capitalization rate are closely related to each other, but distinguishable. Generally speaking, the discount rate or capitalization rate may be defined as the yield necessary to attract investors to a particular investment, given the risks associated with that investment. The discount rate is applied only to discounted cash flow (DCF) valuations, which are based on projected business data over multiple periods of time. In DCF valuations, a series of projected cash flows is divided by the discount rate to derive the present value of the discounted cash flows. The sum of the discounted cash flows is added to a terminal value, which represents the present value of business cash flows into perpetuity. The sum of the discounted cash flows and the terminal value is the value of the business.

On the other hand, a capitalization rate is applied in methods of business valuation that are based on historical business data for a single period of time. The after-tax net cash flow capitalization rate is equal to the discount rate minus the long-term sustainable growth rate. The after-tax net cash flow of a business is divided by the capitalization rate to derive the present value. Capitalization rates may be modified so that they may be applied to after-tax net income or pre-tax cash flows or income.

There are several different methods of determining the appropriate discount rates. The discount rate is comprised of two elements: (1) the risk-free rate, which is the return that an investor would expect from a secure, practically risk-free investment, such as a government bond; plus (2) a risk premium that compensates an investor for the relative level of risk associated with a particular investment in excess of the risk-free rate. Most importantly, the selected discount or capitalization rate must be consistent with stream of benefits to which it is to be applied.

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