Finance practitioners and students often confuse interest rates and discount rates. The interest rate is the rate charged against a particular loan, and may differ from one company to another, depending on the quality of collateral and the credit risk involved in a transaction. The discount rate is the rate used to calculate the present value of cash flows in the valuation of a company or project.
Interest Rate Determination in an Economy
Interest rates in an economy are determined by the supply and demand for money. The Federal Bank controls the supply of money and has a certain degree of power to navigate the level of interest rates in an economy by controlling the rate at which banks can borrow from the Federal Bank. The demand for money can be induced through attractive investment policies and lowering of interest rates, but is not under complete control of the government or the Federal Bank. Investor sentiments and future expectations regarding the economy help determine demand for money in an economy. The interaction of demand and supply leads to the determination of interest levels.
Discount Rate for a Project or a Firm
The discount rate is a micro-level concept applied to individual corporations and projects during the valuation process. The discounted cash flows method is used to value the present value of the future expected cash flows for an investment. The estimation of the present value for these cash flows requires the use of a discount rate. The discount rate is also known as the cost of capital for the project and takes into account the risks involved for undertaking an investment. An investment with higher level of risk has a greater discount rate compared to investments with lower level of risk.
Weighted Average Cost of Capital
The discount rate can be estimated by valuing the weighted average cost of capital (WACC) for the project. This requires inputs, including the interest cost for additional borrowing, the tax rate applicable to the company, the proportion of debt or equity being utilized by the project and the cost of equity for the company. The interest cost is usually lower than the cost of equity, owing to the lower level of risk involved as loans are collateralized and the debtors have a first claim on the assets of the creditor in case of a bankruptcy. Also, the legal framework provides companies with a benefit in the form of tax deductibility of interest costs.
Estimation of the Discount Rate
Suppose a firm uses 50 percent debt and 50 percent equity in its capital structure, and the tax rate applicable is 30 percent. Also, the cost of equity is estimated at 20 percent and the interest cost of debt is 10 percent. The WACC for the company is estimated at 13.5 percent [0.5_(0.1)_(1-0.3) + (0.5)*(0.2)]. This value is used as the discount rate when discounting the cash flows for a project to their present value.
Interest Rate as a Component of Discount Rate
The calculation of the discount rate shows that the interest rate is only a component in the estimation of the discount rate. The interest rate is used to capture part of the risks of the project, but the appropriate calculation of the discount rate also incorporates the risk of the equity.