Discount Rate Determinants
The discount rate is the firm weighted average cost of capital. It represents the opportunity cost of investing creditors and shareholders funds in one particular business instead of others with equivalent risk. The discount rate is used to convert expected future free cash flows into present value for all investors.
Required Rate of Return
The required rate of return is the minimum expected return anticipated by the equity shareholders. The better estimation of required rate of return is weighted average cost of capital plus some risk premium to reflect specific risks related to the investment. These variables show the minimum returns that investors should get when making an equity investment in a firm. So, it is also called as ‘Hurdle rate'. There are two approaches to estimate the required rate of return or cost of equity; they are: (i) The Capital Asset Pricing Model, and (ii) The Arbitrage Pricing Model (already discussed in chapter II).
The required return has two components: the nominal risk-free rate (a combination of real risk free rate of return and inflation), a risk premium. Therefore, the Required rate of return is calculated as:
Required rate of return = Nominal risk free rate of return + Risk Premium
The required rate of return for investors will increase/decrease when any of these single components increase/decrease.
Real Risk Free Rate of Return
The real risk-free rate is the minimum return an investor expects for any investment made in securities. The investor would not bear any risk unless the potential rate of return is greater than the risk-free rate. However, risk-free return exists only in theory but not in practice because every investment involves small amount of risk. Thus, the interest rate on Treasury bill issued by the government is often used as the benchmark risk free rate. The standard approach of subtracting an expected inflation rate from the nominal interest rate to arrive at a real risk free rate provides at best an estimate of the real risk free rate.