Introduction
For business in the United kingdom, the Bank of England presents an opportunity to get lower interest rates than when they borrow on private or commercial banks. However, before a business can get a loan, the BoE has first to appraise the value of the business. Discount rates are used to value businesses, particularly those that are closely held (Stanners, 2002; Bank of England, 2002; Fishman, Griffith and Wilson, 1993; Pratt, 1989; Gilbert, 1990; Dukes and Bowlin, 1993). Discount rates is probably the most important, difficult, and misunderstood area of valuing closely held businesses. Businesses are typically valued on the basis of income (Howitt, 1993). Discount rates are critical to the final value estimate. However, there is much confusion about how to develop and use these rates in business valuations.
Discount rates are used to convert some measure of income into an estimate of value (Swad, 1994; Fishman, Griffith and Wilson, 1993; Pratt, 1989; Gilbert, 1990; Dukes and Bowlin, 1993). The measure of income can be various forms of cash flow or earnings. A discount rate is used in the discounted future income method of valuing a business. This method is appropriate when income is expected to grow at varying rates in future years.
In financial theory there are three basic valuation models (Swad, 1994): no growth, constant growth, and variable growth. These models generally assume an unlimited asset life with a perpetual income stream. The value of an asset using the no-growth model is simply the annual income divided by the required rate of return (Dukes and Bowlin, 1993). In the constant-growth model, the estimated long-term growth rate of future income is subtracted from the required rate of return (Gilbert, 1990). On the other hand, in valuation theory, a discount rate represents the required rate of return in an asset-valuation model. The capitalization of income method and the discounted future income method will produce the same result where income is expected to grow at a constant rate if calculated correctly (Fishman, Griffith and Wilson, 1993).
This section shall discuss the effects of discount rates in the financial market and how even an announcement of slight changes is can inevitably disrupt the equilibrium in the financial sector. Such power can both be seen in the public and in the private sector where the Central Bank has the discretion to peg the discount rate. Moreover, this section shall also illustrate the methods on how a discount rate is determined and the role of the Bank of England in discount rates and how it differs with the US Federal Reserve.
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