December 10th, 2008

The discount rate
The discount rate is an important element in the discounted cash flow analysis. The discount rate is a mathematical estimate of the time value of money.  To a smaller extent, it is also the risk of spending money on an investment.  If somebody offers you the choice between \$1,000 today or an amount in a year’s time  Would you prefer \$1,000 now or \$1,100 in a year’s time? What about \$1,200 in two years time?

The investment analysis uses the discount rate which you want cash now vs in the future.

In above example, the discount rate is 10%. That means \$1,100 in a years time is worth \$1,000 today. A 50% discount rate would make it worth \$1,500. Inflation is a key element of the discount rates. The higher the inflation, the higher the discount rate. Many investors look at pure rate of return which is the rate of return that they want plus an rate to reflect the projected inflation rate.  If there is a 10% inflation rate and the investor wants a 10% return, then the investor will need it takes \$1,200 a year from now to equal the value of \$1,000 today.  In this case his actual return over and above inflation was only 10% even though he needed to receive 20% on his money.  The rest related to the devaluation of the purchasing power of the cash.  Remember risk matters. The higher the risk, the higher the discount rate.

Net Present Value (NPV)
The NPV of an investment stream is the estimated present value of the future cash flow stream, using a predetermined discount rate. Future cash is discounted to its present value. This analysis depends on the length of time (i.e. number of years used) and the valuation for the end of that period.  Many valuations cannot predict more than 5 to 10 years therefore the cashflow will be discounted only until the end of the prediction period.  After 5 to 10 years, there are so many different risks associated with the projections that you have to wonder on the accuracy because you cannot predict external risks that may impact your projections.   Who would have predicted the collapse of the asset backed mortgages, the stock market and the car industry 10 years ago?  Ten years ago, certain types of investment vehicles were not even invented.   The valuation assumption is a critical assumption, but often is an estimate based on simple assumptions. Use it with caution.  Remember, your entire analysis depends on those your assumptions.

The Internal Rate of Return (IRR)
The IRR is the discount rate at which the net present value (NPV) of the Investment is \$0.  Analysts use IRR to compare different investments – i.e. the opportunity cost of selecting one investment vs another. They expect higher risk investments to show higher IRRs. If the risk is between two investments is approximately the same, then the best investment will be the one which yields the higher IRR.