In discounted cash flow analysis, which factors influence the discount rate used?

In discounted cash flow analysis, the selection of the correct discount rate is critical. What factors influence the discount rate used? Also, what are the implications for selecting too low a discount rate for land purchase appraisals?

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One Response to “In discounted cash flow analysis, which factors influence the discount rate used?”

  1. cactusgene says:

    An important element of DCF analysis is the determination of the proper discount rate that should be applied to bring the cash flows back to their present value. Generally, the discount rate should be determined in accordance with the following factors:

    – Riskiness of the business or project: The higher the risk, the higher the required rate of return.
    – Size of the company: Studies indicate that returns are also related inversely to the size of the entity. That is, a larger company will provide lower rates of return than a smaller company of otherwise similar nature.
    – Time horizon: Generally, yield curves are upward sloping (longer term instruments command a higher interest rate); therefore, cash flows to be received over longer periods may require a slight premium in interest, or discount, rate.
    – Debt/equity ratio: The leverage of the company drives the mix of debt and equity rates in the overall cost of capital equation. This is a factor that can be of considerable importance, since rates of return on debt and equity within a company can vary considerably.
    – Real or nominal basis: Market rates of interest or return are on a nominal basis. If the cash flow projections are done on a real basis (non-inflation adjusted), then the discount rate must be converted to real terms.
    – Income tax considerations: If the cash flows under consideration are on an after-tax basis, then the discount rate should be calculated using an after-tax cost of debt in the cost of capital equation.

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    If the discount rate you select in a land appraisal is too low, then the appraised value will be too high and possibly way beyond the true market value.

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