The Discount Rate Explained
The discount rate is the interest rate at which commercial banks and other financial institutions can borrow money from their central bank for short-term, usually overnight, loans. The US Federal Reserve maintains a lending facility for discount rate loans known as a discount window. The discount rate is generally lower than the interest rate consumers get for loans.
In corporate finance, the discount rate allows analysts to calculate the future cash flows to their present value, known as a discounted cash flow (DCF) analysis. The discount rate is also known as the risk-free rate. There is no ideal discount rate, as it depends on the analyst’s interpretation and analysis of financial conditions with predictions about future central bank monetary policy.
How to Use the Discount Rate?
Central banks have various discount rate programs. The US Federal Reserve has three tiers plus an emergency credit line. Lenders use discount rate loans as a last resort, as it signals weakness by the lender to cover financing requirements in the open market. All central bank loans are collateralized, meaning lenders have to meet and maintain certain asset levels for the duration of the loan. Central banks often levy higher discount rates versus interest rates to discourage lenders from tapping funds frequently.
During a discounted cash flow (DCF) analysis in corporate finance, the discount rate helps during investment planning. It offers an analysis of the viability of the investment versus keeping money in the bank, judged on the rate of return or return on investment (ROI).
Discount Rate Types
The Federal Reserve has a three-tiered discount system. Tier-1 is the primary credit program, tier-2 is the secondary credit program with higher rates, and tier-3 is the seasonal credit program.
The discount rate types in corporate finance are:
- Weighted Average Cost of Capital (WACC), which calculates a company’s enterprise value and is the rate of return investors expect
- Cost of Equity, which is the rate companies pay to their shareholders
- Cost of Debt, which is the interest rate companies pay on debt
- Predefined hurdle rate, which is the minimum return for corporate project investments
- Risk-Free Rate, which is the rate for risk-free investments like bank deposits
Examples of a Discount Rate
Below are two examples to show investors can use a discount rate to make an investment decision.
The formula to calculate the discount rate is:
DR = (FV/PV)1/n - 1
Where:
FV = future value
PV = present value
n = number of years until FV
Example:
FV = $10,000
PV = $6500
n = 7 years
Therefore:
DR = ($10,000/ $6,500)1/7 - 1
Or:
DR = 0.06347 or 6.347%
The formula to calculate the present value of a future cash flow using the discount rate is:
Present value = Future cash flow / (1 + discount rate)t
Where:
t = time
Example:
Future cash flow = $10,000
Discount rate = 4.5%
t = 7 years
Therefore:
Present value = $10,000 / (1 + 0.045)7
Or:
Present value = $7,348 (rounded down to the nearest dollar)
Discount Rate Conclusion
A discount rate in central bank borrowing reflects the rate at which commercial banks and other financial institutions can borrow money from the central bank. In most cases, the discount rate is higher than the interest rate.
A discount rate in corporate finance helps companies make financial decisions, but analysts must consider changing interest rates and inflation environments. Therefore, using the wrong discount rate can lead to false predictions.
A high discount rate suggests a lower value of future cash flows and could include assumptions about higher inflation, higher interest rates, or increased risk. It also requires increased future cash flow to make an investment viable versus keeping cash in the bank.
