Companies use discounted cash flow analysis to determine whether the future cash flows they expect to receive from a project will be worth the required upfront investment. A key element in the process is the discount rate -- the rate used to convert those future cash flows into "today's dollars" so they can be compared with the upfront costs. Discount rates are highly dependent on risk. If a project is riskier than average, the discount rate must be adjusted upward.
Cost of Capital
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Every company should have an idea of its cost of capital. That's how much it costs the company to use money for capital projects such as expansions or product introductions. If you borrow $100,000 to remodel your store, and the bank charges 7 percent interest, then your cost of capital for that loan is 7 percent. If you take $100,000 of your own money -- or money raised from investors -- and use it for a remodel, then the cost of capital is the return you give up by not using that money on something else. If you could have invested it in the stock market at an 8 percent annual return, then your cost of capital is 8 percent. In discounted cash flow analysis, you use your cost of capital as your discount rate.
See AlsoDiscount Rate
Present Value
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Say that you've determined that your average cost of capital -- your combined cost of using money from all sources -- is 10 percent. You're considering a project with an upfront cost of $100 that will produce an estimated $60 each of the next two years. You convert those amounts to "present value," or today's dollars, using your discount rate of 10 percent. The formula for discounting a cash flow is: PV = CF/(1+r)^t, where "PV" is present value, "CF" is the cash flow, "r" is the discount rate, and "t" is the time interval in years. The present value of next year's cash flow is: PV = $60/(1.1)^1 = $54.55. The present value of the second year's cash flow is: PV = $60/(1.1)^2 = $49.59. Total present value is $104.14. That's more than the $100 cost, so the project is profitable.
Adjusting Upward
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As the risk of a project rises, so will its cost of capital. That's because if an investment poses greater risk, it must offer a greater return to make the risk worth it. Your bank may be happy to lend you money at 7 percent to remodel your current store, for example, but if you want the money to expand into an unproven area it may demand a higher interest rate to compensate it for the danger that the store will fail and you won't be able to repay the loan. When a project is judged to be riskier than the projects you normally pursue, the discount rate you use in your present-value calculations will have to rise as well. In the project from the previous example, say you used a discount rate of 15 percent. The total present value drops to about $97.54. That's less than the $100 upfront cost. Because of the added risk, the project isn't worth the investment.
Setting a Rate
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Determining the proper risk-adjusted discount rate for a project is usually an inexact science, especially for a small business without formal risk-management procedures. In practice, many business managers essentially "eyeball it" based on their expectations and experience. Say your cost of capital for average-risk projects is 10 percent. If you view a project as slightly riskier, you may bump your discount rate up to 10.5 percent or 11 percent. If it's considerably riskier, you may go up to 16 percent or more. The conservative business person will favor a higher discount rate, because doing so is more likely to prevent taking unacceptable risks.
