Click here to learn about Canada’s COVID-19 Economic Response Plan and support available for individuals and businesses
We often direct our blogs to investors and business owners who evaluate what a reasonable price would be to pay for an investment given the expected cash flow and associated risks. We recognize cash flow risk by applying a discount rate. By discount, we are referring to the business and inflation risk we’re taking to accept a promise of money in the future rather than today.
Let’s use a simple example: assume we have $100 to invest and your friend asks to lend it to him so he can buy a car. He promises to pay the entire debt back in one year. Rather than automatically saying ‘no’, let’s formulate a reasonable discount rate using a build-up method.
Generally, we start with a risk-free rate. In our case we’ll use the current rate for a 20-year Canadian Bond. We also have to consider alternative uses of the money such as investing in equity markets. In today’s market a 5% premium might be considered reasonable. We also apply a risk premium to account for your friend’s current financial situation. In this case, the built up discount rate is 15.34% as described in the table below.
While this calculation can become significantly more complex, it is the market that ultimately decides the appropriate discount rate.
So what payback amount should we ask from our friend for the one-year loan? If we think the 15.34% discount rate is appropriate then we should ask for $115.34 ($100 * 1.1534).
Let’s do the same exercise on a common problem older people wrestle with – what is the best age to start receiving CPP? We will assume we qualify for the top rate and we don’t need the money to live. First you need facts on how CPP works.
Currently, the top benefit at 65 years old is $12,780 per year which is reduced by 0.58% per month down to age 60. If we wait to take benefits at a later age, the rate increases by 0.70% per month up to age 70. If we take CPP at 60 years old, the annual benefit is reduced to $8,333 but we get to collect five years earlier. If we wait until 70 years old, annual benefits increase to $18,148 but we have to wait five years to get it.
We still have to apply a discount rate because we’re waiting for our money. I think it is reasonable to use the 20-year Canadian Bond rate, 2.337%. Using the same methodology above, we get the following results:
So the results are clear; sort of. If you live past 80 years old, you should wait until 70 to start collecting CPP. If you die before 80 but after 73 you should start benefits when you’re 65 years old; otherwise, start at 60.
Of course, things are never that simple;
Now you see that we can use financial analysis to answer everyday financial questions.
CPA, CA, CBV
Partner - Advisory Services
Mike has over 25 years of experience providing accounting and business advisory services, with a focus on the Canadian insurance industry.
CPA, CA, CBV
Alex Wong is a partner at Smythe Advisory and is focused on being a trusted business advisor to his clients.
CPA, CA, CBV
Director of Valuation Services
Paul Woodhouse focuses on providing financial advisory and litigation support services to clients.
Gagandeep specializes in M&A advisory engagements, as well as business valuations in the contexts of management buyouts and succession planning.
Arthur’s mandate is to assist Smythe clients in Western Canada in preparing for and executing business divestitures or acquisitions.