Discount Rates

The second major problem will be in applying NPV rule, i.e., what rate should be used to discount cash flows? As a principle we use the opportunity cost of capital as the discount rate.  The Discount rate is the rate at which the cash flows will be discounted to know the net present value of the future cash flows.

The combination of the cash flows and the cost of capital (the discount rate) must account for

• the risk of the cash flows,
• the financing mix of the investment, and
• the tax benefits associated with the use of debt financing.

As long as these three elements are properly incorporated into the analysis, the results will be correct.