1. Discount Rates Managerial Accounting Prepared by Diane Tanner University of North Florida Chapter 13

2. 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

3. 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 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 Occurs when a company  Issues stock  Earns profit which increases net worth

4. Calculating the Cost of Capital 4 Assets = Liabilities + Owners’ Equity Creates interest expense which reduces profit Debt FinancingEquity Financing Creates a cost consisting of returns to investors  Dividends  Stock value growth thru earnings retention 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 in Weighted average cost of capital

5. 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. 6 The End