Chapter 6

Discount rate
Objectives:
- Understand the meaning of discount rate
- Understand the method of determining the
components of the discount rate
- Understand how to calculate discount rate in
different cases

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 Chapter 6
Discount rate
- Meaning: reflects the minimum rate of
return to be achieved of the project
- Determining methods:
+ Based on cost of capital
+Based on opportunity cost
+ Based on the level of risk

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 Contents

1 Cost of capital
1.1 Cost of debt
1.2 Cost of preferred shares
1.3 Cost of common shares
2 Weighted average cost of capital (WACC)
3 Weighted marginal cost of capital (WMCC)

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 1. Cost of capital

 Cost of capital and required rate of return

 Cost of debt
 Cost of preferred shares
 Cost of common shares

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 Discount rate

The discount rate is the required rate of return on an

investment

The discount rate is employed in evaluating an

investment. The higher the discount rate, the lower the
Present value of the investment.

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 Required rate of return
The required rate of return on an investment is the
equivalent rate of return the investor can earn from
investing in the financial market if he bears the same
risk.
When investing in a company or an investment project, it's
necessary to ask the question: "How does the investment
project or company's risk level compare to the market?" If
the risk of the investment project is higher than the market
risk then the investor must demand compensation for the
increased risk.

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 Cost of capital
The cost of capital is the opportunity cost of investing
with an amount of raised capital, calculated by the
amount of profit that must be achieved on the raised
capital to maintain the expected profit for common
shareholders' equity without reducing it.

The cost of capital depends on the risk of investing with

raised capital rather than the source of capital. If
capital is invested in a high-risk asset, the cost of
capital will be higher.

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 1.1 After-tax cost of debt
The after-tax cost of debt for a project or a company is the
effective interest rate of the borrowing after adjusting for income
taxes.
If a company borrows $2000 with an interest rate of 10% and a
corporate tax rate of 30%:
- Interest payment: $2000 * 10% = $200
- Reduction in pre-tax profits: $200
- Tax reduction: $200 * 30% = $60
- Actual cost borne by the company when borrowing:
$200 - $60 = $140
The after-tax cost of debt: $140 / $2000 = 7%

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 The cost of debt when issuing bonds

If a company raises debt through bonds, the cost of debt

(pre-tax cost of debt) is essentially the Yield to maturity
(YTM) of the bond, determined by the formula:
n
I M
Pnet   
t 1 (1  RD ) (1  RD )
t n

In which: the cost of debt is denoted as RD, M is the face value

of the bond, and Pnet represents the proceeds from issuing the
bond, equal to the selling price minus issuance costs.
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 The cost of debt when issuing bonds
For example: A company issues bonds with a face value
of $100, a bond interest rate of 9%, a maturity of 3
years, and the bonds are sold on the market at a price of
$96. The average issuance cost is $1 per bond.
(Assuming a corporate tax rate of 30%)
The company's cost of debt that it has to pay when
issuing bonds, RD, is determined using the following
formula:
3
100 ∗ 9 %
95 = ∑ ¿
𝑡=1
¿¿
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 After-tax cost of debt

The after-tax cost of debt that the company has to pay when
issuing bonds (R'D) is determined using the following
formula:

3
100 ∗ 9 % ( 1 −30 % )
96 − 1(1 −30 % )=∑ ¿
𝑡 =1
¿ ¿
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 Example: Cost of debt
The data from the previous slide is supplemented as
follows: If the company borrows 2000 million (VND),
the interest rate is 10%, and the corporate tax rate is 30%.
The loan term is 3 years, with annual interest payments
and principal repayment at the end of the 3rd year.
Transaction costs for obtaining the loan: 50 million.

Requirement:
1.Calculate the pre-tax cost of debt: RD.
2.Calculate the after-tax cost of debt: R' D. (Considering
that transaction costs are not included in reasonable
costs)
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 1.2 Cost of preferred shares
- The cost of preferred stock is essentially the amount
the company must pay for the issuance of preferred
shares.
- The dividend payment for preferred shares is taken
from after-tax profits, thus it's not subject to tax
deductions.
- The cost of utilizing preferred shares is calculated
using the following formula:
Pnet = Dp/Rp  Rp = Dp / Pnet
Where Pnet equals the selling price minus issuance costs,
Rp is the required rate of return of the investor, and D p is
the dividend.
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 1.2 Cost of preferred shares

Enterprise A issues preferred shares to raise capital.

The issue price is $96 per share, and the issuance cost
is $1 per share. The annual dividend payment is $12.
Determine the cost of capital for the preferred shares
of the enterprise.

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 1.3 Cost of common share
1.3.1 Cost of retained earnings

The cost of retained earnings is the opportunity cost for

common shareholders, or in other words, the rate of
return that common shareholders could earn by
investing in equivalent risk assets in the financial
market.

There are three approaches to estimating the cost of equity (Cost

of Common Equity):
- Bond yield plus risk premium
- Constant dividend growth model
- Capital Asset Pricing Model (CAPM)
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 1.3.1 Cost of retained earnings
Gordon growth model
Assuming the company has:
A constant dividend growth rate, g,
The selling price of a share is Po,
The just-paid dividend is Do,
The required rate of return for the shareholder is R s. Rs
can be determined using the stock pricing formula as
follows:

D0 (1  g ) D1 D1
P0    Rs  g
( RS  g ) ( Rs  g ) P0
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 1.3.1 Cost of retained earnings
Gordon growth model

- Advantages: simple, easy to understand,

straightforward to apply
- Disadvantages:
+ Assumes a constant growth rate which is not realistic
+ Doesn't clearly depict the relationship between
earnings and risk
+ Cannot be applied to companies that do not pay
dividends

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 1.3.1 Cost of retained earnings
Gordon growth model

For example, Company A has just paid a dividend (D 0)

of VND 2400 per share. The company's shares are
currently trading on the market at a price of VND
25,000. The expected perpetual dividend growth rate of
the company is 5%.

Calculate the company's retained earnings cost.

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 Cost of retained earnings: CAPM
Expected return on an investment depends on the following:
RF : The risk-free rate of return (Government bond rate)
: Historical average risk-free rate of return
RM: Return on the market portfolio
: Historical average return on the market portfolio
Market risk premium ( –)
E(RS): Expected return on stock S
Cov( R S , R M )
βS 
δ 2 (R M )
CAPM: 𝐸 ( 𝑅 𝑆 ) = 𝑅 𝐹 + 𝛽 𝑆 ¿
From the historical data: 𝐸 ( 𝑅 𝑆 ) = 𝑅 𝐹 + 𝛽 𝑆 ¿
 CAPM

 Systematic risk and unsystematic risk

Systematic risk: Operational risk and

financial risk

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 CAPM

Advantages of CAPM:
- Provides insight into the direct adjustment of required
returns and asset risk.
- More widely utilized than the dividend growth
model.
Disadvantages of CAPM:
- Relies on historical data to estimate the beta
coefficient.

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 CAPM
The data for the past 4 years of stock returns (denoted as
Rs) and market returns (denoted as Rm) are as follows:
Year Rs Rm
1 -9% -6%
2 18% 16%
3 9% 11%
4 19% 18%

Determine beta of stock S. Given the risk-free rate is

7%, the average risk-free rate of the past 4 years is
8%. Calculate the required rate of return for stock S
using CAPM. 22
 1.3.2 Cost of new common shares
Dividend growth model

Assuming the company has:

• A fixed dividend growth rate, g.
• The selling price of a share is Po.
• The cost ratio of issuance calculated on the issuance price
is F.
• The just-paid dividend is Do.
• The required rate of return of the shareholders is R E.
We can determine RE based on the stock pricing formula as
follows: D (1  g ) D D
P0 (1  F )  0
 1
 RE  1
g
( RE  g ) ( RE  g ) P0 (1  F )
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 1.3.2 Cost of new common shares
Dividend growth model
Example: Company A has just paid a dividend (D0) of 2400
VND per share. The company's stock is currently trading on
the market at a price of 25,000 VND. The company's
dividend growth rate is expected to be a constant 5%
perpetually.
a) If the company issues new common shares to raise
capital, it incurs issuance costs of 8% of the issuance price.
Calculate the cost of new common shares (RE) for the
company.
b) Assuming the issuance cost is 1400 VND per share,
determine the RE.
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 2. Weighted average cost of capital- WACC

Weighted Average Cost of Capital (WACC) is the

overall return rate on a company's assets that
includes both debt and equity components.
WACC = (D/V)*RD (1 – T) + (Ep/V)*Rp + (Es/V)*Rs
D is the market value of debt.
Ep is the market value of preferred equity.
Es is the market value of common equity.
V = D + Ep + Es

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 2. Weighted average cost of capital- WACC

Example: A company has 1.4 million shares of common

stock outstanding. The current market price per share is
$20. The company has issued bonds with a total face
value of $5 million, currently trading in the market at
93% of face value, with a coupon rate of 11%. The risk-
free rate is 8%, the market risk premium is 7%. The
estimated beta coefficient of the company is 0.74. The
corporate tax rate is 34%. Calculate the Weighted
Average Cost of Capital (WACC) for the company.

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 2. Weighted average cost of capital- WACC

Solution :
Find RE by CAPM
RE = Rf + betaE (RM – Rf)
RE = 8% + 0.74* 7% = 13.18%
E = $20 *1.4 = $28 (mil)
D = $5* 93% = $4.65 (mil)
D + E = $28 mil + $4.65 mil = $32.65 mil
WACC =(4.65/32.65)*11% *(1- 34%) + (28/32.65)*13.18% =
12.34%

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 2. Weighted average cost of capital- WACC

Using the company's WACC as the required rate of return

for the company's investment projects requires
consideration:
Not all of the company's projects have the same risk level
as the company's existing operations. The required rates of
return for the projects must be adjusted based on the risk of
each specific project.

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 2. Weighted average cost of capital- WACC

Example
Risk Example Adjust Discount rate

High New product +4% 19%

Medium Cost savings,
(Compare to extend current 0% 15%
the company) production
Low Replace the old
machine -4% 11%

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 Capital market line

Expected
return
SML

B
19%
15% A
11.8%

7%

Beta
0.6 1 1.5 30
 Weighted marginal cost of capital - WMCC

Weighted marginal cost of capital

The marginal cost of capital is essentially the WACC
of the most recent capital raised.

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 Discount rate - WMCC
Example 1:
Company T has an optimal capital structure as follows: Long-term debt:
25% Preferred shares: 15% Common shares: 60%
- The company expects earnings after deducting preferred stock dividends
for this year to be $34,285.72. The company plans to distribute dividends at
a rate of 30%, and the corporate income tax rate is 20%. Securities investors
in the market forecast a 9% increase in the company's future income and
dividends. The company has already paid a dividend of Do = $3.6 per
preferred share. The company's stock price is $60 per share.
- During its business operations, if there is a need for capital, the company
can raise new capital from the following sources:
1. Common shares: The cost of issuing new common shares is 10% if the
issuance value is <= $12,000 and 20% if the issuance value is > $12,000.
2. Preferred shares: The preferred shares of the company have a dividend of
$11 per share and are sold at a price of $100 per share. The cost of issuing
new preferred shares is $5 per share if the issuance value is <= $7,500 and
will increase to $10 per share if the issuance value is > $7,500.
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 Discount rate - WMCC
 Borrowed capital: When there is a need for borrowing, the cost of borrowed
capital will be as follows:
Amount of loan Interest rate
Từ $0 - $5000 12%
>= 5000 - $10000 14%
>= $10000 16%
 Yêu cầu:
 a. Xây dựng đồ thị đường chi phí vốn cận biên cho công ty
 b. Công ty có các dự án đầu tư được cho trong
.
bảng sau:
Dự án Nhu cầu vốn ($) IRR (%)
A 10.000 17,4
B 20.000 16
C 10.000 15
D 20.000 14,51
E 10.000 12
 Hãy xây dựng đường cơ hội đầu tư (IOS). Xác định ngân sách vốn tối ưu cho
công ty.

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 Discount rate - WMCC
 Solution
 Break points:

 BP debt 1=5000/25% = 20.000 (usd)

 BP debt 2 = 10000/25% = 40.000 (usd)
 BP preferred shares = 7500/15% = 50.000 (usd)
 BP retained earnings = 34285.72*70%/60% = 40.000 (usd)
.
 BP common shares = (34285.72*70%+12000)/60% = 60.000 (usd)

 WMCC1 = 25%*12%*(1-20%) +15%*(11/95) + 60%*(3.6*1.09/60 + 9%) = 13.461%

 WMCC2= 25%*14%*(1-20%) +15%*(11/95) + 60%*(3.6*1.09/60 + 9%) = 13.861%
 WMCC3= 25%*16%*(1-20%) +15%*(11/95)+60%*[(3.6*1.09)/(60*0.9)+ 9%] = 14.697%
 WMCC4= 25%*16%*(1-20%) +15%*(11/90)+60%*[(3.6*1.09)/(60*0.9)+ 9%] = 14.793%
 WMCC5= 25%*16%*(1-20%) +15%*(11/90)+60%*[(3.6*1.09)/(60*0.8)+ 9%] = 15.338%

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 Discount rate - WMCC
Example 2: The joint-stock company T has an optimal capital structure as follows:
Long-term Debt: 40% Preferred Shares: 3% Common Shares: 57%
- The company anticipates a total after-tax profit of 11.4 billion VND remaining
after paying dividends on preferred shares this year. The company plans to allocate
40% of this amount to pay dividends, retaining the remaining portion for
reinvestment. The corporate income tax rate is 20%. Securities investors in the
market forecast a 9% annual increase in the company's future dividends. The
company has already paid a dividend of Do = 2400 VND per common share. The
normal stock price of the company upon issuance is 30,000 VND per share.
- During business operations, if there is a need for capital mobilization, the
company can raise new capital from the following sources:
1. Common stock capital: The cost of issuing new common shares is 10% of the
issuance price if the issuance value is 13.68 billion VND, and it's 20% of the
issuance price if the issuance value exceeds 13.68 billion VND.
2. Preferred stock capital: The preferred shares of the company have a dividend of
12,000 VND per share and are sold at a price of 100,000 VND per share. The cost
of issuing new preferred shares is 5,000 VND per share if the issuance value is <=
300 million VND, and it will increase to 7,000 VND per share if the issuance value
exceeds 300 million VND.
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 Discount rate - WMCC
 3. Borrowed Capital: When there is a need for borrowing, the cost of borrowing
capital will be as follows:

Loan Interest rate

Til 4 bil đồng 15%
Over 4 bil til 8 bil 16%
Over 8 bil đồng 17%
 Required:
 a. Establish the WMCC .
 b. The company has the following projects:

Project Investment (bil dong) IRR (%)

A 9 17
B 10 16
C 9 15,5
D 8 14
E 10 12
 Establish the Investment Opportunity Schedule. What is the optimal amount of
budgeted capital. 36
 Discount rate - WMCC
 Solution
 Break points:
 BP debt1=4/40% = 10 (bil)
 BP debt2 = 8/40% = 20 (bil)
 BP preferred shares = 0.3/3% = 10 (bil)
 BP retained earnings = 11.4*0.6/57%= 12 (bil)
 BP common shares = (11.4*0.6+13,68)/57% = 36 (bil)
 Ks =17.72%; Kp1=12.632%; Kp2= 12.903%; Ke1 =18.689%; Ke2=19.9%
.

 WMCC1 = 40%*15%*(1-20%) +3%*(12/95) + 57%*(2.4*1.09/30 + 9%) = 15.279%
 WMCC2= 40%*16%*(1-20%) +3%*(12/93) + 57%*(2.4*1.09/30 + 9%) = 15.607%
 WMCC3= 40%*16%*(1-20%) +3%*(12/93) + 57%*(2.4*1.09/27 + 9%) = 16.16%
 WMCC4= 40%*17%*(1-20%) +3%*(12/93) + 57%*(2.4*1.09/27 + 9%) = 16.48%
 WMCC5= 40%*17%*(1-20%) +3%*(12/93) + 57%*(2.4*1.09/24 + 9%) = 17.17%

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Discount rates corresponding to different cash flow perspectives

Cash flow Discount rate

NCFEPV Rs
NCFTIP

NCFTIP’
.
 Where:
 Rs: Cost of equity
 S:Market value of equity
 Rd: Cost of debt
 D: Market value of debt
 T: Corporate income tax

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 Summary

- Each perspective to calculate the cash flow requires

a corresponding discount rate.
- The discount rate reflects the required rate of return
for investors, representing the opportunity cost of
investing with the raised capital and the cost of
capital. The discount rate also serves as the hurdle
rate.
- To determine the discount rate, it's necessary to
consider the components of the cost of capital.

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