Question

One of the basic financial principles is that the value of any asset (whether it be a stock, a bond, or a firm as a whole) is the present value of that asset’s future cash flows. As you learned in this chapter, finding present values requires determining a discount rate. Assume you want to buy a business, and you want to find the present value of its future cash flows. Name at least one variable you should consider in determining the correct discount rate to use and explain its role in discount rate determination. If possible, try to identify a variable that has not yet been mentioned by your classmates.

Answer 1

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AS FOR GIVEN DATA...

One of the basic financial principles is that the value of any asset (whether it be a stock, a bond, or a firm as a whole) is the present value of that asset’s future cash flows. As you learned in this chapter, finding present values requires determining a discount rate. Assume you want to buy a business, and you want to find the present value of its future cash flows. Name at least one variable you should consider in determining the correct discount rate to use and explain its role in discount rate determination. If possible, try to identify a variable that has not yet been mentioned by your classmates.

EXPLANATION ::-

In determining the discount rate (also referred as the Interest rate), we make use of many factors. The discount rate is a factor of Expected rate of return by the producer (base rate), saver’s time preference for current v/s future consumption, riskiness and inflation percentage of the economy.

One of the most widely used factors in computing the discount rate is inflation premium. This refers to the increased change in prices of commodities from today to future. This factor is added to the discount rate as it is very important to account for the inflation rate prevalent in any particular economy. The inflation premium gets added to the expected discount rate to compute the required discount rate which can be used to value the assets of the firm being bought.

Discount rate = Expected rate + Inflation premium

For example, in the USA the current inflation rate is 2.13%. In developing countries like India, it is 2.49% and in Europe, it is 1.4%.

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