IRR Series, Part 3: The Discount Rate

Last time we talked about the time value of money. That concept that the same amount of money received now is more valuable to us than money we receive at some point in the future. This is for three reasons:

  1. Money held in my hand decreases in value over time due to inflation. Even if I were somehow guaranteed to get all that money back, I wouldn’t have the benefit of using that money myself for 5 years. If I loan someone $100,000 today paid back in five years, that $100,000 check five years from now has the purchasing power of $83,000 today. That means it cost me 17 grand to do that loan.
  2. We can’t do anything with money that is owed to us but unpaid. Why would I loan $100,000 to an acquaintance who will pay only $100,000 back in five years? It makes no sense. That money could be invested in some other vehicle making a certain rate of return that I wouldn’t be getting here.
  3. Finally, I don’t have a guarantee that the acquaintance will actually pay me my money back. There is risk involved. Even with a signed document stating he will pay me back, in the end all I have is that paper. He might go bankrupt. I might be able to go after him in the courts, but if there is no money there, I’m just wasting more of my money on lawyers. I might be loaning money to my very own brother but there is still a small amount of risk that he won’t be able to pay me back, and that would hurt our relationship. This is why people say you should never loan money to family. Just give it as a gift and don’t expect it back. Remember Bobby from Part 1.

The Discount Rate

We use these three notions to come up with a thing called a discount rate. Mathematicians in the group will start to have their eyes water, because it gets very touchy-feely and, while there is logic to it, precision goes out the window. I’m truly sorry about that. I’ll try to make it as un-mathy as possible for you. The steps mirror the reasons given above:

  1. We first need to predict what we think inflation will be over the term of the loan (we will hypothetically use 5 years). 3.7% is a good place to start. We need to at least be getting this amount of return so that our investment amount is returned with the same purchasing power. This way we will break even.
  2. We next need to consider opportunity cost, or whatever we could reasonably make in some other investment vehicle that would carry equal or less risk. We are in an uncertain period. During COVID, when I started writing this, the five-year U.S. Treasury Bond rates, we get a terrible 0.41%. This is before inflation, so putting your money in this bond will mean you are losing money, due to inflation as above. That being said, inflation will decrease as the economy slows down. But, you say, I could put my money into the stock market. Interesting idea. We might get a higher return, but we will have more risk. In the past 10 years, you could get a 7-10% gain on your investment. Today, it’s anybody’s guess. More uncertainty creeps into our calculations. Let’s say we think we can get at least 5% return out of our blue-chip stock picks and we think we have low risk. If we want to make this 100k loan then we need to get at least 5% return or we would be better off putting it into the stock market. But, loaning money to an acquaintance is probably more risky than the stock market, so we need to put a premium on this risk, and that brings us to…
  3. We need to make an educated guess as to how much risk we take on making this loan. In other words, how much return do we need to be promised to justify the risk that we will lose some or all our money? Do we think we will lose just some, or could we lose it all? Depends on the venture, which is why we would be smart to ask a lot of questions about why our acquaintance needs the money. Let’s say he is starting a restaurant. We might wonder why he is doing so in the midst of a pandemic. We probably wouldn’t do that loan at any rate of return. What if he is starting a surgical mask factory? Maybe there is something there. Maybe we find he has done all the research, has found that his mask is better than others out there. We know there is a demand. What happens when the pandemic is over? There is risk there, too. We might look at rates of return on other factories to compare. We might see how our acquaintance did on other business ventures. Let’s say that after all this research, we think we need to have slightly better than an 18% return to entice us to make the loan. If we reasonably believe that our acquaintance can pay us the large returns, then we might be interested in doing the deal at some amount higher than 18%.

The 18% figure we calculated is the Discount Rate. Think of it as the amount of money that you lose each year in order to make the loan above. It is inflation along with risk. The risk is the tricky part because it used a lot of gut analysis (read: estimation) to arrive at some amount with which we are comfortable. At that rate, the value of our $100,000 stays the same year over year. If the investment is successful, the actual amount on the balance sheet is increasing but that money is discounted for inflation and our calculated risk. At the end of the five-year term, we are paid back a sum of money that purchases the same amount of goods as our 100k would have purchased at the start of the term. Not a great deal. That is why we want to make our loan be better than the 18%, and that is why the discount rate is sometimes called the hurdle rate. For those of you who are IRR savants, I’m getting very close to telling you about the IRR, but I won’t spill the beans just yet. The Discount Rate is then used to calculate the Net Present Value, which we will talk about next time.

Dr. Equity

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