What is the Discount Rate?
Definition: Discount rate is a tool for evaluating the present value of future cash flow of a business. Further, this tool plays a critical part in the role of the central bank (Federal Reserve in the US) as a lender of last resort as the lender of last resort in the country.
The discount rate is an important element in the world of finance. Depending on the context in which you are using it, discount rate has two definitions. From the perspective of discounted cash flow (DCF) analysis, discount rate is the rate of return that businesses use to express the net present value of the business’ expected future cash flow. Investors use the discount rate to express the value of their money over a period of years if they invest in a business today.
In the context of the central bank like the Fed, the discount rate is the interest that a country’s central bank charges on overnight loans to commercial banks. Oftentimes, a commercial bank opts for such a loan to cover for capital shortfall meant for short-term obligations. It means that the commercial (or financial institution) cannot find other lenders in the market and opts for the central bank as the lender of last resort.
Breaking down the Discount Rate: A Guide
For the purpose this article, we will focus on the discount rate as applied in discounted cash flow analysis. A business is an investment and there is a need for the business owner or investor to be certain about the possibility of a good return in future. It makes little sense to commit funds to a project that does not guarantee good returns in future. This is because there are numerous investment opportunities. Every investment decision that one makes has an opportunity cost and the lesser the opportunity cost the better.
The theoretical framework of the discount rate in the context of DCF analysis is that money has a time value. Additionally, there is the uncertainty risk associated with foregoing to use money today and to opt to have the money in future. As such, the discount rate gives a business owner or an investor the means to all these quantitatively.
Therefore, a high discount rate implies that the uncertainly risk of the investment is high. This means that the net present value of such an investment is very low. On the contrary, a low discount rate implies that the net present value of expected future cash flow is high. Usually, riskier investments have high discount rates but their future returns are usually high.
Discount Rate Example
The most obvious category of stakeholders that rely on the discount rate is the investors. Investors always have a goal when they put money in a business. After a certain number of years, the investors expect to have accumulated a certain amount of profit. Further, the discount rate can help investors to determine the amount of money they need to invest today so that they can achieve a certain sum after a given number of years.
For example, there is Investor X who is interested in investing in Company Theta. The investor wants to have an amount of $300,000 in his account after 5 years and at a discount rate of 7% but he is unsure about the amount he should invest today. Let us help Investor X to determine this amount.
Discount Rate Formula
The Discount rate formula calculated like this: FV = PV (1 + i)n
Where FV = future value
PV = present value
i = discount rate
n = number of years over which the investment is discounted.
Investor X’s FV is $300,000, the discount rate (i) is 7% but what he wants is the PV. Feeding the values in the formula gives:
300,000 = PV (1.07)7
= 1.6058PV
PV = 300,000 ÷ 1.6058
= 186,825.
Therefore, Investor X will need to invest $186,825 today.