The "Risk" of Discount Rate

Episode 30 - 06 Apr 2016

The calculations for Present Value (PV) and Net Present Value (NPV) look so elegant...

... so perfect...

... so pure.

But hiding beneath the surface is a Great Big Hack: the Discount Rate!

Links mentioned in the video:

Net Present Value (NPV) in one of my favourite concepts in all of finance and accounting.

But lurking beneath the elegance of its equations...

... is a slippery little fellow.

I'm referring, of course, to the Discount Rate.

Quick recap

We've come a long way in the last couple of episodes:

"A bird in the hand is worth two in the bush" led us to the incredibly useful concept of Present Value (PV):

The idea that money now is worth more than money in the future.

We then turned out attention to expenses: money going out

And discovered exactly the same rule applied:

An expense now has a greater value than an expense in the future.

We then took a step beyond the concepts...

... and we started to perform some calculations.

We even cranked up a spreadsheet to help us perform a multitude of calculations.

Danger Ahead

As we moved from concept to calculation...

we crossed a threshold.

We unwittingly strayed into dangerous waters.

This equation looks so elegant...

... so mathematical...

... so pure.

But lurking within it is something that's far from pure.

The Discount Rate.

Breaking it down

The Discount rate can be considered to consist of two elements:

  1. The Time Value of Money
  2. The Risk Premium

The Time Value of Money

Let's start with the easy one: the Time Value of Mone.

For our purposes here, we'll consider this to be the RISK FREE time value of money.

Its value in percentage points is the INTEREST RATE you could get from a risk-free bank account.

Risk Premium

Here's the FT's definition:

"The additional return an investor expects from holding a risky asset rather than a riskless one"

Unfortunately, that doesn't really help us to put a number on it.

One man's sure thing is another man's unacceptable risk.

Over the years many different methods for determining risk premiums have been proposed.

If you'd like to get a sense of the the variety - and complexity - you could do better than take a look at this page on Quora this page on Quora

You'll be pleased to know that I don't intend to go into any of these details;

My intention today was to make the point that picking an appropriate Discount rate can be tricky.

More Art than Science.

All is lost?

If Discount Rate is so tricky to determine,

does this undermine everything we've looked at so far?

Not at all.

Finance and accounting folks are wiley creatures.

They are not the types to let little bit of uncertainty hold them back.

They've come up with cunning ways around the uncertainty.

We'll take a look at a couple of them in the next episode.

Talk to you then.

Watch "The "Risk" of Discount Rate" on YouTube.