How Much Does a 1-Percentage-Point Rise in the Discount Rate Change Business Value?
The present value of identical cash flows varies with the discount rate and timing. Learn to distinguish cost of equity from WACC and align currency and inflation assumptions when assessing rate sensitivity.
With cash flows unchanged, a higher discount rate lowers present value. The size of the decline depends on when cash is received and the share of value represented by terminal value. Because changes in market interest rates can also affect revenue and earnings, actual stock prices do not move solely according to the discount-rate formula.
The discount rate represents investors’ required compensation
An uncertain KRW 100 in the future differs from a certain KRW 100 today. The discount rate incorporates compensation for time and risk into present-value calculations. The cost of equity is shareholders’ required return; WACC combines the cost of equity and debt according to the capital structure. Standard models use market-value weights and consider tax effects on the cost of debt. Assuming a normal tax shield when deductions cannot actually be used can understate the cost of capital.
Align currency and inflation assumptions
Cash flows forecast in Korean won require a discount rate consistent with won-denominated risk and inflation conditions. Applying a dollar discount rate to won cash flows simply because dollar interest rates are lower can omit exchange-rate and inflation differences. Match nominal cash flows with a nominal discount rate, and inflation-adjusted real cash flows with a real rate. Do not substitute government bond yields of different maturities and currencies as the risk-free rate without explanation. Record the valuation date and interest-rate sources so you can later distinguish changes in business expectations from changes in model inputs.
Distant cash flows are more sensitive to discount-rate changes
A company generating most of its cash today responds differently to a given discount-rate change from one expected to become profitable far in the future. The compounding effect accumulates over longer discount periods. In sensitivity analysis, first hold cash flows constant and vary only the discount rate; then examine a separate business scenario including changes in borrowing costs and demand. Distinguish the roles of your assumptions: sharply reducing cash flows for risk and adding the same risk premium to the discount rate can double count pessimism.
Worked example
Hypothetical example: KRW 11 billion received in one year has a present value of KRW 10 billion at a 10% discount rate and approximately KRW 9.910 billion at 11%. If the same KRW 11 billion arrives in 10 years, the respective present values are approximately KRW 4.241 billion and KRW 3.874 billion. Cash flows are held constant in this calculation. It shows that distant cash flows suffer a larger proportional decline when the discount rate rises by 1 percentage point.
What to check
- Does the discount rate match the cash flows’ currency and nominal or real basis?
- Have you matched FCFF with WACC and FCFE with the cost of equity?
- Have you avoided counting the same risk in both cash flows and the discount rate?
- Have you separated the effects of discount-rate changes from changes in business cash flow?
Sources and primary materials
This is educational material about research methods. For an actual company decision, verify the filings and primary sources for the relevant period.