A discount rate is the rate of return used to discount future cash flows back to their present value Show
What is a Discount Rate?In corporate finance, a discount rate is the rate of return used to discount future cash flows back to their present value. This rate is often a company’s Weighted Average Cost of Capital (WACC), required rate of return, or the hurdle rate that investors expect to earn relative to the risk of the investment.  Other types of discount rates include the central bank’s discount window rate and rates derived from probability-based risk adjustments. Why is a Discount Rate Used?A discount rate is used to calculate the Net Present Value (NPV) of a business as part of a Discounted Cash Flow (DCF) analysis. It is also utilized to:
Types of Discount RatesIn corporate finance, there are only a few types of discount rates that are used to discount future cash flows back to the present. They include:
Discount Rate Example (Simple)Below is a screenshot of a hypothetical investment that pays seven annual cash flows, with each payment equal to $100. In order to calculate the net present value of the investment, an analyst uses a 5% hurdle rate and calculates a value of $578.64. This compares to a non-discounted total cash flow of $700. Essentially, an investor is saying “I am indifferent between receiving $578.64 all at once today and receiving $100 a year for 7 years.” This statement takes into account the investor’s perceived risk profile of the investment and an opportunity cost that represents what they could earn on a similar investment. Example (Advanced)Below is an example from CFI’s financial modeling course on Amazon. As you can see in the screenshot, a financial analyst uses an estimate of Amazon’s WACC to discount its projected future cash flows back to the present. By using the WACC to discount cash flows, the analyst is taking into account the estimated required rate of return expected by both equity and debt investors in the business. WACC ExampleBelow is a screenshot of an S&P Capital IQ template that was used in CFI’s Advanced Financial Modeling Course to estimate Amazon’s WACC. To learn more, check out CFI’s Advanced Valuation Course on Amazon. Issues with Discount RatesWhile the calculation of discount rates and their use in financial modeling may seem scientific, there are many assumptions that are only a “best guess” about what will happen in the future. Furthermore, only one discount rate is used at a point in time to value all future cash flows, when, in fact, interest rates and risk profiles are constantly changing in a dramatic way. When using the WACC as a discount rate, the calculation centers around the use of a company’s beta, which is a measure of the historical volatility of returns for an investment. The historical volatility of returns is not necessarily a good measure of how risky something will be in the future. Additional ResourcesThank you for reading CFI’s guide to Discount Rate. To keep learning and advancing your career, the following CFI resources will be helpful:
What happens to present value when discount rate decreases?A lower discount rate leads to a higher present value. As this implies, when the discount rate is higher, money in the future will be worth less than it is today.
Why does an increase in discount rate decrease the present value of future cash flows?The higher the discount rate, the lower the present value of those cash flows. This is because the investor is expecting to earn a higher rate of return on their investment than the discount rate. An example of a discount rate would be the rate of return that an investor expects to earn on a bond.
How does discount rate affect future cash flows?The discount rate is by how much you discount a cash flow in the future. For example, the value of $1000 one year from now discounted at 10% is $909.09. Discounted at 15% the value is $869.57. Paying $869.57 today for $1000 one year from now gives you a 15% return on your investment.
When the discount rate increases the present value of any future cash flow?When the discount rate increases, the denominator dividing the future cash flow increases; as a result, the present value decreases. This is because as the expectation of interest increases and a lower amount needs to be invested today for the desired future cash flow.
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When discount rate decreases the present value of any future cash flow increases
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