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Lecture 5:
Discount Rates
Outline 2

0. Motivation

1. Economic Framework

2. In Practice
 Motivation
Problem: In order to value an asset (firm, security, property, etc.), we need
to know the right discount rate 3
 Motivation 4
There are many questions we want to answer:
• How should you estimate the right discount rate?
• What is the cost of capital? Is that the same thing as the discount rate?
• How do discount rates vary across companies?
• How do discount rates look over the business cycle?

Why should I care about answering these questions?

1. Relevant for many careers
 Operations / Consulting – often evaluate projects based on “return on
invested capital” compared to “cost of capital”
 Buy side (equity, debt analyst, private equity) –understanding whether value
stems from cash flows or discount rates
 Sell side (banking) – Valuing firms and selling securities
2. Helpful for forming your own views on many world events
- for example, how do investors’ discount rates change during crises?
 Motivation 5
There are many questions we want to answer:
• How should you estimate the right discount rate?
• What is the cost of capital? Is that the same thing as the discount
rate?
• How do discount rates vary across companies?
• How do discount rates look over the business cycle?

Can we answer these questions using intuition alone?

 Intuition is helpful for thinking about the general size of discount rates
for very risky or very safe assets, but it is too imprecise to rely on,
particularly when comparing assets that appear very similar

Can we rely on statistical approaches to estimating discount rates?

 Statistics are helpful for providing benchmarks, but statistics doesn’t tell
us how much to deviate from benchmarks and why. Moreover, some
assets don’t have comparables.
Economic Approach
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Because intuition and statistics are helpful, but not fully

insufficient for understanding and estimating discount rates,
we will use economics to help guide us.

We will develop a theoretical framework to think about

discount rates.

We will then apply this framework in practical settings to

estimate discount rates in real-world settings. You have
covered this topic in FM422, but we will go more in depth to
discuss important strengths and limitations of implementing
this framework in practice.
 Definitions
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What’s the difference between a discount rate and the cost of capital?

Solution:
The discount rate is a valuation input that captures how much cash someone
would be willing to trade today in exchange for expected cash flows in the
future.
Expected Future CF = Present cash flows*(1+r)

The cost of capital refers to how much investors in the market place would charge
you for borrowing their money. For example, the cost of equity tells you the
return that investors would require if you wanted them to purchase equity in
your firm.

When we estimate the market value of an asset, we are essentially asking how
market participants would value the asset. Thus, we use the cost of capital as
the discount rate for our asset.

Our private value of an asset might involve using a discount rate that does not
equal the market cost of capital.
 Asset pricing models
There is a large, and very active field in economics that is centered around8
estimating investors’ cost of capital

For securities trading, asset pricing models can be quite sophisticated.

In corporate settings, we often use the CAPM to estimate a discount rate

for a given asset.

The key ingredients in the CAPM are the following:

1. Perfect capital markets: Supply = Demand (of market securities),
investors have perfect information, there are no transaction costs,
investors are risk averse, etc. etc.
2. Optimization problem: Investors choose portfolio weights over
securities to maximize their portfolio’s expected return subject to a risk
constraint.
CAPM: Theory
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 CAPM: Practice
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Question: Your firm is considering buying a license for oil exploration in Alaska.
Immediately after paying for the license you will invest $50M in a drilling tower.
There is a 10% chance that there will be 10M barrels of oil in the ground and a 90%
chance that there will be nothing. The license specifies that you must sell all the oil
you find to the government in one year from now for $95 per barrel. The risk-free
rate is 5%, the market risk premium is 6%, and the average unlevered asset beta of
oil companies is 0.5. What is the maximum amount you are willing to pay for the
license?

Question: The CEO of Nike argues that the firm should not use the CAPM for capital
budgeting because the firm only produces clothing and footwear, i.e. is not well
diversified. Is this sound reasoning?

Question: Private equity investors (such as VC’s) typically invest in 10-20 companies
within a given fund. Should you use the CAPM to evaluate these companies?
 CAPM: Practice
In practice, estimating the cost of capital using the CAPM requires estimating
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three quantities: rf, β, and E[rm-rf].

Estimating the risk-free rate:

 The risk-free rate is often proxied by the yields on safe government securities (such
as bonds issued by the U.S. Treasury)

 Government securities have different maturities. Ideally you want to match the
maturities of the government securities to the timing of the project’s cash flows, to
ensure that you are capturing the time-value of money that an investor has over the
project’s time horizon.
 CAPM: Practice
In practice, estimating the cost of capital using the CAPM requires estimating
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three quantities: rf, β, and E[rm-rf].

Estimating the expected market risk premium, i.e. E[rm-rf]:

 Method 1. Take the historical average of risk premia for a diversified index of assets
that proxies for the “overall market” (such as the MSCI World Index or S&P 500
index)
 Method 2: Follow consensus recommendations by expert forecasters
 Method 3: Compute implied Market Risk Premia from index valuations and
dividend yields. You essentially use current prices to back out the implied market
risk premia used by investors to value index constituents.
 CAPM: Practice
In practice, estimating the cost of capital using the CAPM requires estimating
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three quantities: rf, β, and E[rm-rf].

Estimating β:
 For equities, you can run regressions using historical returns. The estimate of β is
the slope of a regression line where you regress a firm’s stock return on the market
return (e.g., such as the S&P 500 return)

 Analysts typically use a two- to five-year time horizon and weekly or monthly stock
returns to estimate equity betas.

 These betas are often computed in real-time by companies like Bloomberg and
Yahoo finance.

 What are some examples of high vs. low beta stocks?

 CAPM: Practice
In practice, estimating the cost of capital using the CAPM requires estimating
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three quantities: rf, β, and E[rm-rf].

Estimating β:
 For debt, many analysts assume that debt is risk-free (ie. has a beta of 0). This is
technically at odds with CAPM theory, since in the real-world, almost all debt has
some risk of default that is correlated with the market’s expected return.

 This assumption is used because debt is traded infrequently in practice, so it is hard

to observe enough pricing data to estimate betas using regressions.

 This is often forgiven, however, because even if debt betas were to be estimated,
they would be quite small, as they are fixed income instruments that are low-risk,
especially for investment grade debt.

 When people do use non-zero debt betas, they typically use figures that range
between 0.1 to 0.5.
CAPM: Practice
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Au D

DTS E
 CAPM: Practice
These equations simplify further if we make assumptions about how firms16
choose their financial strategies, which simplifies the expected return on the
firm debt tax shields.
 CAPM: Practice
These equations simplify further if we make assumptions about how firms17
choose their financial strategies
 CAPM: Practice
These equations hold in terms of betas as well as returns (covariance is a linear
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operator if we assume rm is fixed; otherwise it is a bilinear operator).

So when we lever and unlever betas to go from other firms’ cost of capital to
our cost of capital, we must make clear assumptions about the financial
policies that other firms and our firms are making when we choose which
equations we use.

The assumptions that we make will determine whether we are understating or

overstating the cost of capital that investors are using to value assets
 Summary
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To estimate the right discount rate, we first need to consider who is valuing the asset. To
estimate the market value of an asset, we will typically use the cost of capital implied by
market prices.

The CAPM is a commonly used model for estimating the cost of capital from market
prices

We can use CAPM to approximate the cost of capital for our firm, by observing prices for
other, similar firms and estimating their costs of capital

In practice, many people make mistakes by not understanding which formulas to use in
various contexts. Proper application of the CAPM requires making clear assumptions
about the data that you are employing, and understanding how sensitive your estimates
are to changes in your assumptions.