Capitalisation Rate

The capitalisation rate is a discount rate used to calculate the present value of future expenses or cash flows that are incurred in the acquisition or construction of an asset. It is used in accounting and financial modeling to determine the appropriate depreciation expense for an asset.

Formula:

Capitalisation Rate = (1 - Required Rate of Return) ^ -Number of Years

Where:

• Capitalisation Rate: The discount rate used to calculate the present value of future expenses.
• Required Rate of Return: The expected rate of return on the asset.
• Number of Years: The number of years over which the expense or cash flow will be incurred.

Example:

A company purchases a machine for $10,000 and expects to have it for 5 years. The required rate of return is 10%. The capitalisation rate would be:

Capitalisation Rate = (1 - 0.10) ^ -5Capitalisation Rate = 6.16%

The company would depreciate the machine by $6,160 over the 5-year period.

Uses:

• Calculating depreciation expense for assets.
• Adjusting for inflation.
• Estimating future cash flows.
• Determining the present value of future expenses.

Factors Affecting Capitalisation Rate:

• Economic conditions: Interest rates and inflation can affect the capitalisation rate.
• Industry practices: Different industries may have different capitalisation rates.
• Company’s financial health: A company’s financial strength can influence its capitalisation rate.
• Salvage value: The expected salvage value of an asset can affect its depreciation expense.

Note:

The capitalisation rate is a complex concept and should be used with caution. It is important to consult with an accountant or financial advisor for specific guidance.