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I've been reading that interest rates lower the over future cash flows of equities, hence their decline as money can be moved elsewhere for better returns.

What is the direct relationship between interest rates and the rate used in a DCF? For example, if a DCF uses an 8% rate, how/why would rising interest rates increase that from 8% to say 10%?

The DCFs produce a smaller NPV as the discount rate increase, but I'm not sure why rising interest rates would increase a discount rate, unless it's the result of increased costs of borrowing money.

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The rate used in a DCF model is the required rate of return for that investment. It implies that you have other options for where to put your money, and that there is an opportunity cost to committing funds.

Governmental interest rates represent the 'risk free' rate of earnings achievable as an alternative to the cashflow you are modelling. The rate used in a DCF should consider the risk-free rate + an appropriate modifier to account for the additional risk of your particular investment type. If a 7% rate is 'fair compensation' when T-Bills offer 2%, would you really still call 7% 'fair compensation' when T-Bills offer 2.5%?

If the underlying investment hasn't changed [and therefore, has the same risk profile and, simplistically, the same modifier to its required rate of return], then rising interest rates should have similar impacts to most DCF models.

In an extreme scenario, what happens if t-bills rise to 10? Would you really still be okay with 7% equity return [implying the cashflows you are viewing have a lower risk rating than the US government]?

So, required rate of return rises in reflection of the relative increase in the value of risk-free government bonds, the NPV of those cash flows decreases, and investors are no longer willing to pay the same amount to purchase them [the price drops].

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  • This is just an ok answer. For a useful answer I would like to see equations that compare your DCF for the Nasdaq 100 index with your expected future return of T-bills. In particular, how much should the Nasdaq-100 drop for every 1% increase in 10 year T-bill rates? May 16 at 1:24
  • @KeithKnauber lol May 16 at 22:02

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