by Gabriel Andrada, MHA, CSAF, CHBC, CVA
In valuation, “discount rates” refer to the investment rate of return used to convert the future anticipated cash flows of a business to their present value equivalent. The term “discount rate” is synonymous with “cost of capital” or “required rate of return,” which is essentially the rate of return needed for a potential investment to be considered worthwhile based upon its risk profile.
Simply put, the cost of capital represents the interest rate that must be paid to investors to attract their capital. The cost of capital varies from entity to entity based upon the overall risk of the investment. Factors that influence perceptions of risk may include:
- Historical financial performance
- Leverage (debt)
- Age and size of the business
- Sensitivity to industry or economic forces
- Geo-political risk
- Population demographics
- Technology, etc.
As noted above, a discount rate represents a rate of return used to convert a series of future cashflows into a present value. This effectively considers the concept of the time value of money, where cashflows in the present are more valuable than expected cashflows from the future. There is an inverse relationship between present value and risk, whereby expected future cashflows that are less certain (riskier) are discounted more heavily than cashflows that are more certain. In short, the more “risky” the future cashflows of a business is, the higher the discount rate will be, and thus the lower the present value of such cashflows.
At Root Valuation, we help physician leaders successfully navigate business and employment transactions to that their value is fully realized. Have a question about your business valuation, contact us at firstname.lastname@example.org or speak with Gabriel Andrada at 720.634.7025.