What Is the Discount Rate?

What Is the Discount Rate?

By Charles Joseph | Editor, Financial Affairs
Reviewed by Corey Michael | Senior Financial Analyst

The discount rate is a financial concept used in various circumstances, mainly related to the time value of money. It’s a rate of return that is used to determine the present value of future cash flows. In simpler terms, it’s used to calculate how much a certain amount of money expected in the future is worth today.

Let’s say you have the option to receive $100 now or a year from now. Most people would prefer to receive the money now, mainly because it can be invested and earn more over the year. The discount rate reflects this preference as it’s essentially the interest rate that would be earned over the time period it takes for you to receive the cash flow.

Related Questions

1. How is the discount rate used in a discounted cash flow (DCF) analysis?

A DCF analysis uses future free cash flow projections and discounts them, using a desired annual rate, to arrive at present value estimates. The discount rate reflects the risk associated with the future cash flows. If the present value arrived at is higher than the current cost of the investment, the opportunity may be considered a good one.

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2. How does the Federal Reserve use the discount rate?

The Federal Reserve sets the discount rate, which is the interest rate it charges commercial banks for short-term loans. Changes in this rate can encourage or discourage borrowing and thus influence the money supply in the economy.

3. How do you determine the discount rate?

There are several ways to determine a discount rate. It could be the interest rate for a secure, risk-free investment like a U.S. Treasury bond or it could be based on the expected return of a riskier investment. In business settings, a company’s Weighted Average Cost of Capital can be used as the discount rate.

4. What’s the relationship between the discount rate and net present value (NPV)?

The discount rate directly affects the calculation of the net present value (NPV) of a series of future cash flows. Higher discount rates result in lower NPV, reflecting a higher perceived risk and lower overall value of the cash flows.

5. What’s the difference between discount rate and interest rate?

An interest rate is the amount of interest due per period as a proportion of the amount lent, deposited, or borrowed. The discount rate is the interest rate used to determine the present value of future cash flows. They are conceptually similar, but play different roles in financial analysis.