Hi, so here we are in the last video of this module. Today's lecture is about the discount rate. Haven't you had the following question in you mind? How do we determine the appropriate discount rate of a project? So far, the discount rate has been always given in problems. And we just understand that the discount rate is determined by risk of the project or the company. Although, we do not know how exactly to estimate it. So what does the discount rate mean exactly and how should we choose the discount rate of a project? These are the last topics of the module, so let's get started. To understand how the discount rate of a project is determined, we should first explore many topics which at a glance seem to be not so much related to the project discount rate. We start by thinking about different ways of referring to the discount rate. You may remember that in many problems, they use the term required rate of return instead of the discount rate. Many people also use the term cost of capital to refer to the discount rate. Required rate of return is the rate of return investors demand when they invest in the firm. It is investors who evaluate risk of the company and determine the company's minimum required rate of return. If they think, given the risk of the company, the company should give investors the rate of return of, say 9% at least, they will not invest in the company until it promises investors to give 9% return. While investors who'd call it required rate of return, the return to investors is the cost of capital or the cost of borrowing money from the company's perspective. Now you'd understand why the terms, discount rate, required rate of return, and cost of capital, can be used interchangeably. Once the company identifies its cost of capital then the rate will serve as the hurdle rate for the company's investment. If the cost of capital is 20% for example, the company should earn at least 20% on the investment. Otherwise, the company will not earn enough return to compensate its investors for lending their money. Now you'll understand why we had to accept the project only if the IRR is greater than the discount rate, which is the company's cost of capital. If the cost of capital or the discount rate is 20%, as in the previous example, your new project should earn at least 20%. Okay, then what is capital? Or, what are the components that constitute a company's capital? We know that the capital structure of a company consists of debt and equity. Then there must be the cost of debt, and the cost of equity for any company. The cost of debt, for example, is the return that investors require on their investment in debt issued by the companies. We do not learn how to estimate cost of debt and cost of equity of a company today, because it is out of scope of this course. The company's overall cost of capital is the weighted average of its cost of debt and cost of equity. When we calculate the weighted average, the weight of debt and equity are determined by the company's capital structure. We'll see how it works using an example very shortly. The main message here is that the firm's overall cost of capital, which is the weighted average of the firm’s cost of debt and cost of equity, is the discount rate we use in a project analysis. Let's calculate the cost of capital or the discount rate of the company in this example. The company has total assets of $100 million and it consists of $30 million debt, and $70 million equity. That means the weight of debt in this company is 30 million divided by 100 million, which is 0.3. The weight of equity is 0.7. We are told that the after-tax cost of debt is 3% and the cost of equity is 8%. Can we calculate the overall cost of capital of this company? Yes, it's just the weighted average of cost of debt and cost of equity. We'll multiply cost of debt by the weight of debt, and we'll multiply cost of equity by the weight of equity. Then, the sum of these two components is the weighted average, which is the cost of capital of the company. With the estimated cost of capital of 6.5%, we can argue that this company should use 6.5%, as the discount rate whenever it analyzes new projects by using NPV or IRR methods. The company would need to make sure that the new project has the expected rate of return of at least 6.5%. According to what we learned so far, it seems that the cost of capital reflects the overall risk of the whole company. Technically, however, the discount rate we used in the project analysis should reflect the risk of the specific project that we are analyzing, not the risk of the company. Nevertheless in practice the company’s cost of capital is widely used in a project analysis. The assumption that practitioners make by using the companies cost of capital is that the project has the same risk as the firm. This is true in most cases, however, if you believe that the new project risk is significantly different from the overall company risk, you should apply the new rate which is different from the company's cost of capital.