Discount Rate Defined
What is the Discount Rate?
Discount rate is the rate of return used to discount future cash flows when calculating an investment’s present value.
A discount rate is applied to future cash flows because money earned in the future is less valuable than money earned today.
This is based on the principle that money should make more money over time – a concept known as the “time value of money.”
Discount Rate Meaning
Only publicly traded companies are legally required to disclose their financial information, and so only public companies are required to file a 10-K form, although private companies may elect to do so as well.
When is the Discount Rate Used?
The discount rate is often used when computing a company’s Weighted Average Cost of Capital (WACC), and is used as a “required rate of return,”or the “hurdle rate”that companies and investors expect as a return on their investment.
Companies will have different discount rates since they will have different expectations for what return their investments should make for the company.
In general, newer companies that are growing will have a higher internal rate of return and therefore use a higher discount rate when discounting future cash flows.
Discount Rate Purpose
A company’s discount rate is used to calculate the net present value of an investment.
The net present value (or NPV) of an investment is what the value of future cash flows is worth today.
If an investment’s net present value is a positive number, then it is considered a wise investment since the returns were greater than the investor’s or company’s required rate of return, another name for “discount rate.”
Discount Rate Example
Discount Dave considers investing $6,000 in a new machine that will generate $1,000 a year for its useful lifetime of 7 years.
Without factoring in a discount rate, it seems that Discount Dave’s investment is profitable, since $7,000 is greater than $6,000.
However, when he applies a 10% discount rate to his future cash flows, the present value of future cash flows is only $4,695.
After subtracting his original investment of $6,000, his investment’s net present value is -$1,305.
Since his investment would lead to a loss after factoring in the discount rate, Discount Dave looks for a better investment.