Discount Rate
The most widely used method of discounting is exponential discounting, which values future cash flows as "how much money would have to be invested currently, at a given rate of return, to yield the cash flow in future." Other methods of discounting, such as hyperbolic discounting, are studied in academia and said to reflect intuitive decision-making, but are not generally used in industry.
The discount rate used is generally the appropriate Weighted average cost of capital (WACC), that reflects the risk of the cashflows. The discount rate reflects two things:
- The time value of money (risk-free rate) – according to the theory of time preference, investors would rather have cash immediately than having to wait and must therefore be compensated by paying for the delay.
- A risk premium – reflects the extra return investors demand because they want to be compensated for the risk that the cash flow might not materialize after all.
An alternative to including the risk in the discount rate is to use the risk free rate. The risk free rate is calculated by multiplying the future cash flows by the estimated probability that they will occur. This method, widely used in drug development, is referred to as rNPV (risk-adjusted NPV), and similar methods are used to incorporate credit risk in the probability model of CDS valuation. (CDS = credit default swap)
Oxera (2011) reviews the selection of a discount rate suitable for the assessment of new and emerging energy technologies.
Read more about this topic: Discounted Cash Flow
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