Discount Rate
BeginnerA discount rate is the interest rate used to convert future cash flows into their value today. A higher discount rate makes future money worth less in today's terms.
Because money today can be invested, a sum received in the future is worth less than the same sum now. The discount rate captures how much less, by reflecting the return that could be earned elsewhere and the risk involved.
Suppose you will receive 1,100 in one year. At a discount rate of 10%, its present value is 1,000, because 1,000 invested at 10% would grow to 1,100. At a discount rate of 5%, the same 1,100 is worth about 1,048 today.
In company finance, the discount rate is often the weighted average cost of capital, possibly adjusted for the risk of a particular project. Riskier cash flows are discounted at higher rates, which reduces their present value.
The choice of discount rate can greatly change results, especially for cash flows far in the future. A small increase in the rate can sharply reduce the value of a long-term project or company.
The phrase is also used by central banks for the interest rate they charge banks for short-term loans, which is a different meaning.
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