Discount rates and capitalisation rates explained.

In a business valuation, a capitalisation rate (cap rate) is the discount rate minus the expected long-term growth rate of earnings: cap rate = discount rate − g. The discount rate is built up from a risk-free rate plus a market risk premium, adjusted for size and company-specific risk. Prismi documents each component, because a two-point change in the rate can move the concluded value more than most earnings disputes.

Why the rate is worth arguing about

In an income-based valuation, the discount or capitalisation rate does the same job as the multiple in a market-based approach — it converts a stream of earnings or cash flow into a present value. The relationship is direct: value moves inversely with the rate, and the sensitivity is often larger than most people expect. A dispute over whether maintainable EBITDA is $950,000 or $1,000,000 is a 5% swing in the numerator. A dispute over whether the appropriate rate is 18% or 20% can be a larger swing in the denominator — and rate arguments are usually less visible to a reader because they sit in a paragraph of qualitative reasoning rather than a reconciled schedule of add-backs. A report that asserts a rate without building it up, in line with IVS 104 and the reporting standard set by APES 225, invites exactly this kind of challenge.

Discount rate vs capitalisation rate: the growth bridge

A discount rate and a capitalisation rate are related but not interchangeable terms in a business valuation. A discount rate is applied to a full set of forecast cash flows in a Discounted Cash Flow (DCF) model — each year's cash flow is discounted back to present value at that rate, then a terminal value is added. A capitalisation rate is applied to a single, normalised maintainable earnings figure in the Capitalisation of Maintainable Earnings (CME) method — one number is capitalised (divided by the rate) to produce a value in a single step. The bridge between the two is the long-term growth rate: capitalisation rate equals discount rate minus the expected long-term growth rate of the earnings stream (cap rate = discount rate − g). A report that states a capitalisation rate should be able to show what discount rate and growth assumption sit behind it — silence on either input is a gap worth asking about.

The build-up method and CAPM

Most Australian SME valuations build the discount rate using a build-up method, often informed by the Capital Asset Pricing Model (CAPM) framework rather than applying CAPM in its pure listed-market form. Each component should be sourced and stated, not asserted as a single blended figure with no working shown.

• ·Risk-free rate — the yield on Australian Commonwealth Government long-dated bonds at the valuation date, not an assumed round figure
• ·Market risk premium — the additional return investors require for holding diversified equities over the risk-free asset, drawn from published Australian market studies
• ·Size premium — smaller entities carry additional risk relative to the market indices the market risk premium is drawn from, so an SME rate is built up, not read directly off the index premium
• ·Company-specific risk premium — an adjustment, up or down, for customer concentration, key-person dependency, competitive position, management depth and earnings reliability
• ·Resulting discount rate — the sum of the above, reasoned line by line rather than presented as a single unexplained percentage

Converting multiples to cap rates as a cross-check

A capitalisation rate and an earnings multiple are mathematically the reciprocal of each other: multiple = 1 ÷ capitalisation rate, and capitalisation rate = 1 ÷ multiple. This is a useful cross-check rather than a separate methodology. If an income-based approach produces a capitalisation rate of 20%, that implies a multiple of 5.0x maintainable earnings — a figure that can be tested against comparable market multiples for similar businesses. Conversely, if market evidence points to a 4.5x–5.5x range for comparable entities, the implied capitalisation rate range is roughly 18%–22%, which the build-up rate should sit within or explain a departure from. Where the two approaches diverge materially, the report should reconcile why a build-up rate implying a multiple well outside observed market evidence needs revisiting.

Common errors: mismatched cash flow and rate definitions

The most frequent technical error is mismatching the cash flow definition to the rate definition. A discount rate derived from an equity-return build-up (cost of equity) should be applied to free cash flow to equity (FCFE) or to earnings after interest — not to free cash flow to the firm (FCFF), which is a pre-financing, whole-of-capital-structure measure requiring a weighted average cost of capital (WACC). Similarly, a rate built on a pre-tax basis should be applied to pre-tax cash flows, and a post-tax rate to post-tax cash flows — mixing the two produces a systematic bias in one direction. Applying a cost-of-equity rate to an FCFF stream, or a post-tax rate to pre-tax earnings, can move the concluded value by a material margin without any change to the underlying business. A reviewer checking a report should confirm, in one sentence, which cash flow definition and which tax basis the stated rate was built for.

Sensitivity: what a point of rate movement is worth

Because capitalisation works by division, the relationship between rate and value is not linear — it compounds as the rate falls. Illustrative example only (figures are generic, not a recommendation): maintainable EBITDA of $1,000,000 capitalised at 20% produces an enterprise value of $5,000,000. The same earnings capitalised at 18% produces $5,555,556 — an increase of over 11% for a two-point rate reduction. Capitalised at 22%, the same earnings produce $4,545,455 — a fall of around 9% for a two-point increase. The lower the rate, the larger the dollar swing per point of movement, which is why company-specific risk premium judgements deserve the same documented reasoning as an add-back schedule. A report that discloses the rate build and runs a sensitivity table around it gives the reader the tools to see how much of the concluded value depends on a single judgement call.

Which engagement tier covers the rate build

Every Prismi report states the discount or capitalisation rate and the reasoning behind it — the difference between tiers is how deep the sensitivity testing and cross-checking goes. Essential (from $1,495 + GST, 10–14 business days) documents the build-up rate applied and its components, suited to straightforward single-entity matters where the rate is not expected to be contested. Comprehensive (from $3,995 + GST, 15–25 business days) is the standard recommendation where a Div 152 concession claim, a restructure or a related-party transaction is at stake — it tests the capitalisation rate against the implied multiple as a cross-check and documents the company-specific risk premium loading line by line, consistent with the supporting-evidence expectations in the ATO's market valuation guidance. The Defensible Valuation File (from $8,995 + GST, 25–35 business days) is built for matters where the rate itself is likely to be challenged — it includes a full sensitivity table showing value movement across a range of rates and sourced evidence for every component. Where an adviser needs to see how the concluded value moves under several rate and growth scenarios before a negotiation or board decision, the Valuation Range & Scenario Review (from $12,995 + GST, 30–45 business days) models those scenarios explicitly. Retrospective valuation dates attract a $495 surcharge per historical date — relevant here because the risk-free rate component must be sourced to that date, not the current one — and additional entities are $750 each.