Blog / InspirationWednesday, May 27, 2020

Discount rate formula [2020] | All you need to know about discount rate

Anne Egdal

Discount rate formula [2020] | All you need to know about discount rate

If you plan to secure investment to help you grow your SaaS business, the discount rate is a crucial metric of which you will need to have a grasp.

Why is Discount Rate Important?

Your discount rate will play a role in both your current reporting and your future planning. The discount rate will tell you how financially viable future projects are, giving you a view of whether you should continue with your SaaS development plans.

Setting your discount rate isn’t straightforward. You will need to factor in variables like your company’s equity, debt, and inventory.

Understanding your discount rate will help you to understand what your SaaS business might be worth in the future, in comparison to what it’s worth now.

With such knowledge, you can set to work growing from where you are now to where you want to be.

What is the Discount Rate?

How you define the discount rate depends on the context.

The discount rate will either be the interest rate you use to calculate the net present value (NPV) of your business or the interest rate your bank charges you for short term loans.

For this guide, we're going to look at the discount rate from an NPV perspective and not worry about interest rates from the bank.

When you define your discount rate, you have two formulas you can use; weighted average cost of capital (WACC) and adjusted present value (APV).

We will look at both in this guide.

First, we need to know more about NPV.

What is Net Present Value (NPV) and Discounted Cash Flow (DCF) Analysis?

You will need to know your NPV so you can conduct an adequate discounted cash flow (DCF) analysis. Both NPV and DCF use the discount rate in their calculations.

DCF is a standard valuation method that potential investors will use to decide whether your SaaS business is likely to give value from an investment perspective.

Using the discount rate and both calculations will enable you to show whether future cash flow will be larger than what it is currently. If you can prove this to investors, you may stand a higher chance of attracting the investment you need to grow your business.

How to Calculate Net Present Value (NPV)

Your NPV is the difference between your SaaS business' incoming and outcoming cashflows. The discount rate you use and the time over which you decide to measure your cash flow will influence the calculation.

SaaS businesses use NPV to measure the projected profitability of prospective investments over time. When you measure NPV, you will account for inflation and returns. NPV is a common feature in budgeting for capital projects and investment planning.

We’re going to go through the formula for calculating NPV now, but if you want an easy way to work it out, use the Excel formula!

The formula calculating NPV is below:

NPV = [Cash Flow / (1 + i)t] – Initial investment

In this calculation:

i = Required return or discount ratet = Time over which you're measuring

For example, let’s assume you’re looking to develop a new feature for your SaaS platform. You require an investment of $200,000, and you expect the new feature to bring in $50,000 per month of net cash flow over the next 24 months. Your target rate of return, or discount rate, is 5%.

This would give us a working formula:

NPV = [$50,000 x 24 months / (1 + 0.05)24] - $500,000

NPV = [$1,200,000 / 3.2] - $200,000

NPV = $175,000

In this example, you have a positive NPV, which means you will look attractive to investors!

Remember that you are equalizing your cash flow monthly over the time you are measuring. Don't assume you will make $50,000 per month from month one!

How to Calculate Discounted Cash Flow (DCF)

DCF looks at the value of future cash flow to estimate the value of investments.

DCF is a crucial metric if you want to show investors what they can expect to make if they commit cash to your SaaS business.

The formula to calculate DCF is below:

DCF = Cash Flown / (1 + Discount Rate)n + Recurring

In this calculation, n stands for the month number.

For example, if you are looking to calculate your DCF over 24 months, you would make the calculation 24 times and add them together. n would be 1 for month one, 2 for month two, and so on.

DCF will help you tell investors what they would need to invest today to achieve a specific return at a future date.

How to Calculate Your Discount Rate

As we have seen in both the NPV and the DCF calculations, you need to know your discount rate.

As we mentioned earlier, we’re going to look at both the weighted average cost of capital (WACC) and the adjusted present value (APV).

 

What is Adjusted Present Value (APV) and How Do We Calculate It?

APV is a simpler way to calculate your discount rate and makes use of NPV and present value.

SaaS businesses can use this as a way to highlight the potential value of investments if they seem unviable at first glance.

The APV calculation is simple:

APV = Net Present Value + Present Value of the Impact of Financing

The difference between NPV and PV is that NPV is the incoming cashflow minus outgoing cashflow, while present value is simply the incoming cashflow.

This can help you to highlight the impact of getting investment. If you’re currently in negative cash flow, but the investment will enable you to grow your business and achieve positive cash flow, then you’ll look more attractive to an investor.

 

What is Weighted Average Cost of Capital (WACC) and How Do We Calculate It?

SaaS businesses can use WACC to calculate the value of their company. To calculate WACC, you will need to know the cost of goods for sale, equity, and debt.

The WACC formula is below:

WACC = E/V x Ce + D/V x Cd x (1 – T)

In this calculation:

E = value of equity

D = value of debt

Ce = cost of equity

Cd = Cost of debt

V = D + E

T = tax rate

Let’s try to simplify this.

Let’s assume you’ve had a great start to your SaaS journey.

By the time you get to 2025, you expect to have equity (E) of $100,000,000 and have long term debt (D) of $25,000,000.

We now know the value of E, D, and V.

The Cost of Equity can be challenging to calculate, as it doesn't cost your company anything to issue shares. For the sake of this calculation and example, we will keep it as 1.

The Cost of Debt is simply the interest rate you pay against any borrowing. We’ll assume a rate of 2% for our calculation. The tax rate is the rate of business tax you pay. We’ll assume a rate of 20% for this calculation.

That will give us a working formula for WACC:

WACC = E/V x Ce + D/V x Cd x (1 – T)

WACC = 100/125 x 1 + 25/125 x 2 x (1 – 20%)

WACC = (0.8 x 1) + [(0.2 x 2) x (1-20%)]

WACC = 0.8 + 0.32

WACC = 1.12%

 

Using Discount Rate in Your Business

Discount rate can be crucial both for managing the finances of your SaaS business and for attracting investment.

Cash flow in general is a crucial metric to focus on. According to Preferred CFO, 82% of small businesses fail due to a failure to manage cash flow. If you’re looking to attract investment, you will need to prove to investors that you are on top of your cash flow so that you are able to generate a return.

Use the calculations in this guide to help you calculate your discount rate alongside other crucial financial metrics on which the future of your SaaS business may rely.

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