The discount rate is the rate that is used to calculate the present value of future cash flows. In assessing new projects it is often the cost of capital that is used as the discount rate32. Given that a project can have numerous sources of capital, the discount rate is calculated using a weighted average of the cost of capital (WACC) for the various debt and equity instruments used to finance the project.
The simplified calculation for WACC is:
WACC = [cost of debt x (Debt/Total Financing)] + [cost of equity x (Equity /Total Financing)]
Example 1 in Box 3 -2 illustrates the calculation of the discount rate for a project when only equity financing is used. Example 2 calculates the WACC assuming the same cost of capital as in Example 1, but this time the project is financed using 60% debt and 40% equity. As many countries offer tax benefits when using debt financing Example 3, using the assumptions from Example 2, shows what happens to WACC when the tax benefits are factored into the calculation.
Box 3 - 2 Cost of Debt 7% Cost of Equity 15%33 Example 1 WACC equity only = (15% x 100%) = 15% Example 2 60% of project costs are financed with debt and 40% with equity WACC without tax benefit = (7% x 60%) + (15% x 40%) = 10.2% Example 3 Corporate Income Tax Rate = 30% WACC with tax benefit = (7% x 60% x (1-30%)) + (15% x 40%) = 8.9% |
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32 Different financiers may have different discount rates based on another set of criteria.
33 Though 15% is used in this example, the cost of equity capital will vary depending on the source and can be as high as 25% or more.