Welcome back. In this lesson, we're going to look at establishing the right discount factor for our capital budget. Few people know what this is intended to represent. The discount rate represents the cost of capital for the opportunity. If the opportunity is an extension of your existing business model, then the discount rate is the same as your cost of capital for the rest of your organization. However, if this is an unrelated opportunity, then the cost of capital should reflect the nature of the opportunity.

For example, I worked for another utility later in my career, and we used a 7% cost of capital for regulated opportunities and a 9% cost of capital for any on regulated opportunities to compensate for the higher industry risk. Now, I don't like to get too hung up on the formulas for calculating cost of capital, because in my experience, they don't always spit out a sensible answer. In practice, few people use them particularly in private company context. But the larger the company, the more important knowing your cost of capital becomes. Why is this? Well, larger companies have lower costs of capital.

And when you have a low discount rate, it results in more valuable cash flow streams. Look at it this way, you can take your discount rate and convert it into a multiplier by taking your discount rate and dividing it into one. So an 8% discount rate converts to a 12 and a half times multiple. On the other hand, a 20% discount rate equates to only a five times multiple. So this is just one reason that a discount rate matters less to a small company than it does to a large one. Let's say you have $1,000 of annual cash flow at a 20% discount rate, this cash flow is worth $5,000.

However, this very same $1,000 cash flow at an 8% discount rate is now worth $12,500 or 250% more, knowing your discount rate matters and matters even more for large companies that have small discount rates. Working as a financial analyst and the corporate development group of a utility company, cost of capital was something that I worried about. We spent four years looking for a creative acquisition opportunities using our 7% and 9% cost to capital thresholds. But in that time, came up largely empty handed. Now, it's not to say the deals were done in that period of time. In fact, another utility company that was a bit smaller than us did some really large deals in that time and delivered exceptional shareholder value was illustrated by the chart in front of you, when we looked at the cap rates, this company was paying for those acquisitions using our models, those deals would be diluted.

Clearly, there was a disconnect somewhere because we should have had a similar cost of capital. Now, years later, when I reflect back upon this experience, I believe that we were too conservative with our estimate of cost of capital. Utility stocks are valued by the stock market and generally trade at a premium market multiple because of the perceived stability of their higher than average dividend yield in a low interest environment. The effect of factoring this market perception into the cost of capital is that it lowers it 7% suddenly becomes 6% or 5%. And small changes in small discount factors have gigantic effects. Once again, compare the multiples at a 7% the multiple We could pay was 14 times at 6%.

It's 17 times and it 5%. The multiple is 20 times. So the lesson here is that if you are a large company trying to compete against other companies, the cost of capital absolutely matters. However, if you happen to be a small private company, or working for a startup company, as perhaps many of you are, it matters a lot less. And once again, I'm going to challenge you to think why? Well, it's because if you're a small private company, you're likely cost of capital is probably 20% or higher.

If you are in a startup stage, your cost of capital may be 40% or more. Most entrepreneurs don't even think of cost of capital in terms of a percentage return at all. If you ask them how they are making capital budgeting decisions, you make it an answer along the lines, that if I can get my money back in two or three years, I'll make the investment If they have to wait five or six years for a return, then they probably take a pass. So you work the math at a 25% cost of capital works out to the equivalent of approximately a two year simple payback. These kinds of returns are only possible by taking on significant risks and unproven markets. While we are on this matter of discount rate, and cost of capital, allow me to remind you that the cost of capital is the same thing as your weighted average cost of capital or whack.

In other words, it includes all your different sources of debt and equity financing. It is and must always be calculated on an after tax basis. And speaking of taxes, do not ignore taxes, or your analysis is just spitting out garbage. It's a common misconception that you can use pre tax discount rates with pre tax cash flows and arrive at largely the same conclusion. I've mocked up a simple example on the screen and In front of you to prove that it doesn't work that way. And because your discount factor includes both your debt and your equity financing, your cash flows must be those available to service both the lenders terms and the shareholders expectations.

Therefore, you should be calculating what are called unlevered cash flows, ie those without financing costs included. Many times I will see people mix up this part of their analysis by including interest in principal repayments of debt in their capital budgeting analysis. Let's wrap up this lesson by reviewing three key points we discussed. In this lesson we looked at the sensitivity of capital budgeting to the discount rate, small discount rates lead to higher present values. Thus, large organizations with low cost of capital need to spend a little more time thinking about the appropriate discount rate, then say a small private company that has a very high cost of capital. Which brings us to the discount factor, which should represent the cost of capital for the opportunity.

If the opportunity diversifies the organization's line of business, the cost of capital may be higher or lower than the existing cost of capital for the company. And finally, remember that your cash flows must match your discount rate, because your discount rate considers both lenders and shareholders. The cash flows you calculate on an unlevered basis are those available to both lenders and shareholders. That's all for this lesson. In our next lesson, we're going to walk through the capital budgeting process. Until then,