Discussion About Discount Rate Adjustment

Discussion about discount rate adjustment

Let’s start with some assumptions made here. Market efficiency is something people would like to talk about. Transaction costs and market irrationality might actually drive up the expected rate of return, especially for public individual investors.

HOLT framework emphasize on business cycle. The model determine the future cash flow based on the stage the company is at of a normal economic cycle and in turn derive the market implied discount rate by equating the present values of forecasted cash flows to the current market price. The company-specific discount rate is further tuned by factoring in the corporate size and leverage. This is in line with their emphasis, and we believe that this somehow integrates the normal WACC approach into their model. However, we have to cautiously apply this result in case of a different view of the industry and/or of the company. A more accurate assessment of the firms’ strategic movements and economic activities, such merge and acquisitions, would become vital in the model.

Further to above, the article has given the equation to combining the cost of debt and market implied cost of equity, DR = xDrD + (1 – xD)rE. Here, “xD” represents the market leverage. If this stands for an industrial average of industries in the same country, this might be a bit misleading to the sun-set industry where firms are experiencing business contraction and might not be able to maintain the capital structure as before, unless a recovery is expected and achievable to this particular enterprise.

Since we are talking about the real rate of return, the article has offered a guide to investors to estimate future discount rate by looking at five discount drivers - risk-free rate, credit spread, tax rate, volatility and inflation. These are reasonably important factors when someone is estimating the required rate of return using building block approach.

Regarding the mean-reversion, we assume that this has...