2 Answers | Add Yours
The discount rate should be the risk adjusted cost of capital of the firm. It differs for all firms. It is refered to as WACC - Weighted average cost of capital. This may seem circular, but the discount rate is relative to the firm, because it's the firm's business to assess the risks associated with that type of investment.
Google for example understands the risk in developing software, so the market has adjusted Google's capital cost with the expectation that Google knows better than anyone else how to make software investments. If Google instead invested in pharmaceuticals, the discount rate would differ because Google knows nothing about pharmaceuticals and would not likely make as much return as someone that was in pharmaceuticals.
Discount rate is the application of the interest rate--the multiplier converting future returns--to a project with a future value that presents the cost in terms of present value.
When applying the NPV rule, the discount rate should equal the required rate of return.
In this specific case, 5% inflation + 6% real (inflation adjusted) return means that the required rate of return for the project is 11% nominal. If the required rate of return was 6% nominal, then the discount rate should be 6%. However, this presents the problem as a real return and thus must account for inflation. 11% is the correct answer.
We’ve answered 288,094 questions. We can answer yours, too.Ask a question