Rate of return that investors require.
The discount rate, or cost of capital, reflects the rate of return that investors require if they are to invest in the type of project under consideration. It is a blended rate that incorporates both debt and equity and a given level of long-term gearing. In essence, the higher the risk, the higher the returns demanded by investors to tempt them to invest and, therefore, the higher the discount rate. High discount rates reduce Net Present Values (NPVs). Discount rates vary by sector (e.g. utilities generally have lower discount rates than IT companies) and within each sector (e.g. Microsoft will have a lower discount rate than an IT start-up company). Whilst the principles are straightforward, actually calculating a discount rate is hard and prone to error. A standard and widely accepted technique used is the Capital Asset Pricing Model (CAPM).