Joachim Kuczynski, 27 November 2024
The valuation of investments and projects (or assets in general) is based on shifting and adjusting cash flows on the time axis. A shift backwards in time is called discounting. A shift forwards in time is called capitalization. Many analysts use the same rate for discounting and capitalization when valuing a project. But can you really shift the cash flows back and forth on the time axis at the same rate? The answer to this is a clear no.
The discount rate of a cash flow is based on its inherent risk (volatility). In general, it does not depend on the risk preferences of the capital providers, when their investment portfolio is diversified sufficiently. The capitalization rate of a cash flow, on the other hand, is based on the risk preferences and portfolio diversification of the company (or its capital providers). The capitalization rate does not depent on the inherent risk of the initial cash flow. Once it is available for capitalization, it does not matter under what circumstances it came about. Discount rates and capitalization rates are fundamentally different. Taking the same rate in calculations is a fundamental, logical error.
There are key figures for investment valuation that include a recapitalization of returning cash flows. A well-known example is the modified internal rate of return or the Baldwin rate. It is usually assumed that both discounting and reinvestment are carried out using the same rate, the WACC. The WACC is based on the return expectations of the capital providers. However, these do not necessarily have to correspond to the return opportunities of the investing company. Additional rates (“risk premiums”) are often added to the discount rate. This is intended to take currency or location risks into account, for example. If you now use the same rate for capitalization, you assume an increased reinvestment rate for the company. This makes no sense and increases the error in the investment calculation.
In summary, we can state that equating discount rate and capitalization rate is fundamentally wrong. Many formulas are simplified by equating these two rates. But it is simply wrong, anyway. The results of the calculation are no longer valid doing that. However, correct and meaningful results of the investment calculation are the basis for correct investment decisions. So take care and do not simplify what cannot be simplified. Economic reality is complex, and their calculations can be too.