What is Discount Rate?
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It is often the expected rate of return from an investment or the Weighted Average Cost of Capital (WACC). Discounting future cash flowsCash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more is essential as the future money is less valuable than current money as per the concept of the time value of money. Therefore, discounting helps to understand the real value of future money today.
Key Takeaways
- Discount rate refers to the rate of interest that is used to discount all future cash flows of an investment to derive its Net Present Value (NPV).NPV helps to determine an investment or project’s feasibility.If NPV is a positive value, the investment is viable; otherwise not.WACC, Cost of Equity, Cost of Debt, Hurdle Rate, and Risk-free Rate are the types of discount rates applicable.
Discount Rate Explained
Discount rate is the interest rate used to find the net present valueNet Present ValueNet Present Value (NPV) estimates the profitability of a project and is the difference between the present value of cash inflows and the present value of cash outflows over the project’s time period. If the difference is positive, the project is profitable; otherwise, it is not.read more (NPV) of a project’s future cash flows. NPV helps to determine the profitability Profitability Profitability refers to a company’s ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company’s performance.read moreof an investment or project. Therefore, this interest rate determines whether a project is viable or not.
Each company or investor expects certain future cash flows when taking up a project or investmentInvestmentInvestments are typically assets bought at present with the expectation of higher returns in the future. Its consumption is foregone now for benefits that investors can reap from it later.read more. However, these future cash flows can’t be considered as such to determine the feasibility of the project. This is because the value of money decreases with time. Also, there is uncertainty or risk related to the future, which must be taken into account.
Thus, companies conduct a discounted cash flowDiscounted Cash FlowDiscounted cash flow analysis is a method of analyzing the present value of a company, investment, or cash flow by adjusting future cash flows to the time value of money. This analysis assesses the present fair value of assets, projects, or companies by taking into account many factors such as inflation, risk, and cost of capital, as well as analyzing the company’s future performance.read more (DCF) analysis. DCF analysis uses discounting to calculate the project’s value today based on its future cash flows. In other words, it lets investors determine the project’s NPV.
A positive NPV indicates that the present valuePresent ValuePresent Value (PV) is the today’s value of money you expect to get from future income. It is computed as the sum of future investment returns discounted at a certain rate of return expectation.read more of cash flows is greater than the initial cost of the investment, i.e., returns exceed the costs. This means that if the NPV is positive, the project is worthwhile; otherwise, it is not. Thus, investing in such scenarios is a wise decision.
Note that NPV and discount rate have an inverse relationship. The higher the rate, the lower the NPV and vice versa. This is because the future cash flows reduce in value if discounted at a higher rate. Therefore, a lower rate is always desirable.
Discount Rate Types
The future value of an investment doesn’t amount to anything for companies. They can judge the utility of the investment only on the basis of its value today. So discount rate comes in handy to compute the present value of any project or investment.
The companies opt for different rates. For instance, some use the rate of return they wish to receive from the investments depending on the risk involved, while others use their weighted average cost of capitalWeighted Average Cost Of CapitalThe weighted average cost of capital (WACC) is the average rate of return a company is expected to pay to all shareholders, including debt holders, equity shareholders, and preferred equity shareholders. WACC Formula = [Cost of Equity * % of Equity] + [Cost of Debt * % of Debt * (1-Tax Rate)]read more (WACC) as a discount rate.
Therefore, different types of rates apply to the investments based on the nature and the purpose for which they are being used.
- WACC: It is the required rate of returnRequired Rate Of ReturnRequired Rate of Return (RRR), also known as Hurdle Rate, is the minimum capital amount or return that an investor expects to receive from an investment. It is determined by, Required Rate of Return = (Expected Dividend Payment/Existing Stock Price) + Dividend Growth Rateread more that a company’s investors expect in return for capital. It comes in handy to compute the equity valueEquity ValueEquity Value, also known as market capitalization, is the sum-total of the values the shareholders have made available for the business and can be calculated by multiplying the market value per share by the total number of shares outstanding.read more of a company.Cost of Equity: It is the rate of return that a company pays to its equity shareholders. It is used to compute the equity value of a company.Cost of Debt: It is the rate of interest that a company pays to its bondholders. The valuation of fixed-income assets uses it.Hurdle Rate: It is the minimum acceptable rate of return for investing in a project. It evaluates investments in internal corporate projects.Risk-free Rate: It is the rate of return on an investment with no associated risks. It helps assess the time value of money.
Formula for Discount Rate
To calculate NPV, this is how the discount rate is used:
Where,
- F = projected cash flow of the yearR = discount raten = number of years of cash flow in future
Calculation & Examples
Suppose a company makes an initial investment of $2,000, which is likely to yield cash inflows of $1000 per year for four years. The total future cash inflow, in this case, would be $4,000. If the rate is 10%, then the present value calculations are as follows:
Year 1
= $909
Year 2
= $826
Year 3
= $751
Year 4
= $683
Total present value = PV for Year 1 + PV for Year 2 + PV for Year 3 + PV for Year 4
= 909+826+751+683
= $3,169
The initial investment needs to be subtracted from the sum of the present value to determine whether making this investment is profitable or not.
NPV = Total Present Value – Initial Investment
= 3169 – 2000
= 1,169
As the NPV value is positive, the investment is fruitful.
Issues
Though discount rate helps investors find out a project’s NPV and make major investment decisions, there are a few issues that users need to take care of:
- Since future cash flows are uncertain, the NPV calculations using discount rate is, at best, guesswork, which may or may not work.The discount rate remains the same throughout the years of activity, while the interest rates, market conditions, and other factors keep changing constantly.If the NPV computation works well, it adds to the reputation of the company or shareholder, or investor. On the other hand, if things fail, the reputation gets highly hampered.
Recommended Articles
This has been a guide to what is Discount Rate & its Definition. Here we explain the formula to calculate NPV using discount rates along with examples. You can learn more from the following articles –
Discount rate refers to the rate of interest used to discount future cash flows to calculate their present value. In other words, it lets investors compute the net present value of an investment to determine its viability. It is often the expected rate of return, the weighted average cost of capital (WACC), or the hurdle rate.
Different types of discount rates used to calculate the net present value (NPV) of an investment are as follows: • Weighted Average Cost of Capital (WACC) • Cost of Equity • Cost of Debt • Hurdle Rate • Risk-free Rate
The discount rate is applied to the future cash flows to compute the net present value (NPV). NPV marks the difference between the current value of cash inflows and the current value of cash outflows over a period.where, F = projected cash flow of the year, r = discount rate, and n = number of years of cash flow in future
- Discount Rate vs Interest RateInternal Rate of Return (IRR)Corporate Finance