Discount Rate and Financial Asset Returns: The Fundamental Connection

Imagine you are considering starting a small business, perhaps a coffee shop. Before you invest your hard-earned money, you would naturally want to figure out if it’s a worthwhile venture. You’d estimate how much money you expect to make each year and how much it will cost to run the shop. This process of deciding whether to invest in a project, like our coffee shop, is called capital budgeting.

A crucial part of capital budgeting is figuring out the right yardstick to measure the project against. This yardstick is often called the discount rate. Think of the discount rate as the hurdle rate your project needs to clear to be considered a good investment. It’s the minimum return you need to earn to justify putting your money into this project instead of somewhere else.

But where does this hurdle rate come from? This is where the connection to financial assets comes in. The fundamental rule that links a project’s discount rate to the returns available on financial assets is based on a simple, yet powerful idea: opportunity cost.

Let’s say you have some money to invest. You have two main options. Option one is to invest in our coffee shop project. Option two is to invest in the financial markets, perhaps buying stocks or bonds. If you choose to invest in the coffee shop, you are giving up the opportunity to earn returns from those financial assets. Therefore, the return you could reasonably expect to earn in the financial markets becomes your opportunity cost.

To make a smart investment decision, the return you expect from your coffee shop project must be at least as good as the return you could get from investing in financial assets of similar risk. If the coffee shop project is riskier than investing in, say, government bonds, then you should demand a higher return from the coffee shop to compensate you for taking on that extra risk.

This is where the discount rate comes into play. The discount rate for your coffee shop project should reflect the returns you could reasonably expect to earn on financial assets with a similar level of risk. If you could invest in a different business with similar risk and expect a 10% return, then your coffee shop project should also aim to provide at least a 10% return to be considered worthwhile. Otherwise, you’d be better off investing in that other business or in financial assets offering that 10% return.

So, how do we determine the return on financial assets of similar risk? Financial markets offer a wide range of investments with varying levels of risk and return. Generally, investments with higher risk potential tend to offer higher potential returns to compensate investors for taking on that risk. For example, investing in stocks of small, new technology companies is generally considered riskier than investing in stocks of large, established companies or government bonds. Therefore, investors expect a higher return from those riskier tech stocks.

The fundamental rule, therefore, is that the discount rate used for a capital budgeting project should be equal to the expected return on financial assets with comparable risk. This ensures that the company is making investment decisions that are consistent with what investors could achieve elsewhere in the financial markets. If a project cannot generate a return that is at least equal to the return available on similar-risk financial assets, then it is not creating value for the company and its investors. It would be better for the company to simply return the capital to investors so they can invest it themselves in those higher-returning financial assets.

In essence, the financial markets set the benchmark for returns. Companies need to meet or exceed these benchmarks when they invest in projects. By using a discount rate that reflects the opportunity cost of capital, as determined by the returns available on financial assets of similar risk, companies can make sound capital budgeting decisions that maximize value and ensure they are using investors’ money wisely. This fundamental rule is a cornerstone of financial decision-making and helps ensure resources are allocated efficiently within the economy.