Discount Rate

2 Replies

@Daniel Levine

IRR is a great way to evaluate projects, but you don't need to discount the cashflows in order to calculate. A discount rate is used when calculating Net Present Value (NPV).

Discount rate is tough and is a personal decision. When I think about discount rate, I think about the riskiness of the deal, cost of capital and what I might get investing in another opportunity. For Example: "In order to make this investment worth it for me I need to earn 16% over 6 years". 

Unless you're investing in the same thing over and over again, a discount rate could change, like I said before, based on the risk of the deal being evaluated. Calculating risk is difficult and personal. 

In Excel: to calculate IRR just line up the cashflows (horizontally or vertically). In a blank cell type "=irr(CASH FLOW ARRAY)" and it will spit out your return.

Originally posted by @Daniel Levine :

How do I determine a reasonable discount rate? Can I use the cap rate? I am trying to calculate the IRR on a few different investment options. Thanks.

The discount rate (in capital budgeting) and cap rate (used in evaluating commercial or multi family properties), are completely different concepts -- totally different. 

The IRR is the discount rate that makes present value of future cash flows from an investment to equal the initial investment.

If you are looking at say 4 or 5 investment projects, the investment with the highest IRR (%) would theoretically be the best route to invest the funds.

If you were trying to determine the net present value of a project, and wanted to know what 'discount rate' to use, the 'cost of funds' for the project or opportunity cost (what % you can earn elsewhere for the money), could be utilized as the discount rate for purposes of calculating the net present value.