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Short Definition

The rate at which future cash flow is discounted to see the current value. There are several methods of discount rates. Wikiwealth uses the WACC, or weighted average cost of capital.

Long Definition

The term discount rate has two meanings:

• The same as interest rate; the term "discount" does not refer to the meaning of the word, but to the purpose of using the quantity, such as computations of present value, e.g. net present value / discounted cash flow

• The annual interest divided by the capital including that interest; this rate is lower than the interest rate; it corresponds to using the value after a year as the nominal value, and seeing the initial value as the nominal value minus a discount; it is used for Treasury Bills and similar financial instruments

Annual interest divided by the capital including that interest

One meaning of the term discount rate is the annual interest divided by the capital including that interest, which is the interest rate divided by 100% plus the interest rate. It is the annual discount factor to be applied to the future cash flow, to find the discount, subtracted from a future value to find the value one year earlier.

For example, suppose there is a government bond that sells for $95 and pays $100 in a year's time. The discount rate according the given definition is

\frac{100-95}{100} = 5.00\%

The interest rate is calculated using 95 as its base:

\frac{100-95}{95} = 5.26\%

For every interest rate, there is a corresponding discount rate, given by the following formula:

d = \frac{i}{1+i}

or inversely,

i = \frac{d}{1-d}

Business calculations

Businesses need to consider the discount rate when deciding whether to spend some of their profits on buying a new piece of equipment, or whether to give the profit back to their shareholders. In an ideal world, they would only buy a piece of equipment if the shareholders would get a bigger profit later. The amount of extra profit that a shareholder requires in the future in order to prefer that the company buys the equipment rather than giving them the profit now is based on the shareholder's discount rate. There is a widely used way of estimating shareholder's discount rates using share price data. It is known as the capital asset pricing model. Businesses normally apply this discount rate to their decisions about purchasing equipment by calculating the net present value of the decision.

See also

• Amortization
• Debt
• Debt Percentage of Capital
• Equity Percentage of Capital
• Equity Risk Premium
• Fair Value
• Free Cash Flow
• Interest-bearing Debt
• Invested Capital
• Present Value Factor
• Required Return of Debt
• Required Return of Equity
• Risk Free Rate
• Shares Outstanding
• Short-Term Debt
• Value Investing
• Weight Average Cost of Capital (WACC)

See Related Analysis

• WACC Discount Rates

See Related Resources

• WACC Discount Rate Model
• Private Equity Discount Rate
• WACC Calculator

Source: http://en.wikipedia.org/wiki/Discount_rate