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Discount Rates

Managerial Accounting

Prepared by Diane TannerUniversity of North Florida

Chapter 13

What is a Discount Rate? An interest rate Used to determine the cost of money over time Its use in managerial accounting decisions

To determine how much future cash flow amounts are worth in the present

Two common discount rates Weighted average cost of capital

Referred to as the 'cost of capital' or WACC Required rate of return (RRR)

When assessing capital budget decisions Use the required rate of return

2

Cost of Capital

Assets are ‘financed’ by the two equities on the right side of the accounting equation

3

Assets = Liabilities + Owners’ Equity

Occurs when a company Obtains long-term

loans /bonds

Debt Financing Equity Financing

Occurs when a company Issues stock Earns profit which

increases net worth

Calculating the Cost of Capital4

Assets = Liabilities + Owners’ Equity

Creates interest expense which reduces profit

Debt Financing Equity Financing

Creates a cost consisting of returns to investors Dividends Stock value growth thru

earnings retention

Managers weigh the two costs based on the proportion of the

company that is financed by debt and the proportion

financed by equity financing.

Results inWeighted

average cost of capital

Required Rate of Return (RRR)

• Indicates the minimum amount—the hurdle—an investment must meet in order to be accepted

• Also known as the hurdle rate

Required Rate of Return =

Weighted average cost

of capital + Risk % + Inflation %

5

Sometimes a % component for desired profit is added

6

The End