How Discount Rate works in DCF Model
The discount rate in a DCF model helps adjust the value of future cash flows to their present value. This is because money received today is worth more than money received later, due to the time value of money.
In an unlevered DCF, the discount rate is often represented by the Weighted Average Cost of Capital (WACC), which reflects the expected return on investment based on its risk level. Essentially, the discount rate is a measure of how risky the investment is. It's like a minimum return threshold that investors expect from an investment compared to others with similar risks.
Here's how it works:
- Higher Discount Rate: If the discount rate is higher, it means the investment is riskier. As a result, future cash flows are considered less valuable.
- Lower Discount Rate: A lower discount rate means less risk, so future cash flows are considered more valuable.
Imagine you are considering two investment opportunities:
Investing in a Start-up (Riskier Option):
A Start-up promises to pay you ₹1,00,000 after one year. However, since start-ups are risky, you expect a higher return for taking on this risk. Let’s assume the discount rate is 12%.
Investing in a Fixed Deposit (Safer Option):
A fixed deposit (FD) from a reputed Indian bank offers ₹1,00,000 after one year. Since FDs are very secure, the discount rate is much lower—let’s say 6%.
Calculating Present Value (PV)
To calculate the present value of ₹1,00,000 for both options, we use the formula:
PV = FV (1 + r)^n
Where:
- PV = Present Value
- FV = Future Value (₹1,00,000)
- r = Discount Rate (as a decimal)
n = Number of years (1 year in this case)
For the Start-up Investment (12% Discount Rate):
PV = 1,00,000 (1+0.12)^1
= 1,00,000 / 1.12 ≈ ₹ 89,286
For the Fixed Deposit (6% Discount Rate):
PV = 1,00,000 (1+0.06)^1
= 1,00,000 / 1.06 ≈ ₹94,340
Interpretation
- Start-up Investment: The present value of ₹1,00,000 from the start-up is ₹89,286 because of the higher risk involved. This means you value the future ₹1,00,000 less today due to uncertainty.
- Fixed Deposit: The present value of ₹1,00,000 from the FD is ₹94,340 because it carries less risk. You value this future payment more highly due to its security.
Key Takeaway
- A higher discount rate (e.g., 12% for the start-up) reduces the present value of future cash flows because it reflects higher risk.
- A lower discount rate (e.g., 6% for the FD) increases the present value because it reflects lower risk.
This example shows how the discount rate adjusts for risk and helps investors decide which opportunity aligns with their risk tolerance and expected returns.
