The mysteries of "discount rates"

We discuss what discount rates are and how customers use them in their purchasing decisions.

Stephen Jackett
November 2, 2020
Articles

Before we get into the realm of discount rates, the first thing to understand is the fundamental concept of a business case, and what it actually is.

A business case is used in the decision-making process of individuals and businesses to help understand if spending money on products or services (or a project) will give a good return on their investment (ROI). It is typically in the form of a written document, but it could also be a presentation or verbal discussion.  

Generally, a company will be faced with a problem and to overcome that problem they will need to invest in a new or upgraded solution. As a first step, the company will ask providers of that solution to submit a proposal which will contain costs and an explanation of how they will overcome the problem. This is where most proposals stop, but the more successful ones will go on to present and quantify the financial benefit of what solving the problem will mean to the company. It will compare the benefits against the cost which will give the investors (those with the problem) a picture as to if it is worthwhile investing to fix the problem or not! This whole exercise requires us to look into the future to make predictions based upon the company and their unique situation and discuss what benefits could be achieved by implementing the new solution. It’s this concept of looking into the future where the discount rate comes in.

The discount rate (often referred to as minimum return or hurdle rate) is an integral part of a business case as it allows you to determine the present (today) value of future cashflows.  What does this mean? Let me explain.

If I were to offer you a £1 today or a £1 in one years’ time which would you choose?  

Of course, you would choose a £1 today because its worth more to you today than in a years’ time! This difference in value between today and one year is calculated using the discount rate and the same applies to our business case.

Let’s delve in a little further. A business case should contain both the costs of the solution to solve the problem as well as the benefits of implementing that solution. The month-by-month cashflow is made up of the net of these two numbers e.g. £1,000 cost + £100 benefit = £900 (in the red) and so on.  The month-by-month cash position is ‘discounted’ by a 12th of the annual discount rate, added up into a value and then you have your net discounted amount which is either positive (good) or negative (not so good). This is also known as the NPV - Net (sum of the benefits and the costs) Present (discounted by the annual discount rate to a today’s value) Value (amount of money).

Imagine this scenario for a moment. I’m happily running my engineering business, I have a few day-to-day problems – too much scrap, deliveries are normally late and we do get a lot of invoicing mistakes, but the business runs fine and we make money and can pay our bills. In our monthly management meeting our production manager raises a number of these issues with the team and suggests that a new software system could solve some of these problems and even facilitate some business growth. I attempt to kick this idea into the long grass…I don’t want the disruption! However, the production manager has done their homework and presents me with some numbers. The amount that we can save by ordering the correct amounts of material, the impact of not losing customers due to late delivery and the time saved by not having to deal with continuous invoice mistakes, far outweighs what it would cost to implement a new software system (including disruption). This argument is very compelling and makes it extremely difficult to delay or ignore the proposal as there are obvious problems that cost our business money. The business case has been carefully thought through and also includes a discount rate so it’s very difficult to argue against it.

So, now you know what the discount rate is you will probably have a few more questions. These may include, how do I find my customers discount rate? What are the nuances around using discount rates with customers? Are discount rates fixed or can they be negotiated on a project-by-project basis?  Stay tuned for more exciting articles!

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