The discount rate is a financial concept based on the future cash flow in lieu of the present value of the cash flow. The divisor in the discount rate formula is the resultant future value, including income. The concept of a discount rate differs from that of an interest rate, most notably in that the divisor in the interest rate formula is the original investment. Finance studies and addresses the ways in which individuals, businesses, and organizations raise, allocate, and use monetary resources over time, taking into account the risks entailed in their projects. ... This article does not cite any references or sources. ... The present value of a single or multiple future payments (known as cash flows) is the nominal amounts of money to change hands at some future date, discounted to account for the time value of money, and other factors such as investment risk. ... Income, generally defined, is the money that is received as a result of the normal business activities of an individual or a business. ... An interest rate is the price a borrower pays for the use of money he does not own, and the return a lender receives for deferring his consumption, by lending to the borrower. ...

Example

Suppose there is a government bond that sells for $80 and pays $100 in a year's time. The discount rate represents the discount on the future cash flow: A government bond is a bond issued by a national government denominated in the countrys own currency. ...

The interest rate on the cash flow is calculated using 80 as its base:

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

inversely,

Discounted cash flows are cash flows that have had their value decreased by the discount rate, compounded by the amount of time until the cash flow is realized. This accounts for the time value of money when determining the true value of the future cash flow. Summing all appropriately discounted cash flows allows the calculation of the net present value. The internal rate of return is simply the discount rate that causes the net present value of a series of cash flows to be zero. In finance, the discounted cash flow (or DCF) approach describes a method to value a project, company, or financial asset using the concepts of the time value of money. ... This article does not cite any references or sources. ... The time value of money is the premise that an investor prefers to receive a payment of a fixed amount of money today, rather than an equal amount in the future, all else being equal. ... This article does not cite any references or sources. ... In finance, the discounted cash flow (or DCF) approach describes a method to value a project, company, or financial asset using the concepts of the time value of money. ... It has been suggested that this article or section be merged with Discounted cash flow. ... The internal rate of return (IRR) is a capital budgeting method used by firms to decide whether they should make long-term investments. ... It has been suggested that this article or section be merged with Discounted cash flow. ...

Economic policy

One major issue of economic policy is: how to determine an appropriate discount rate? Because the discount rate can have a dramatic effect on central reserve banking systems (including several levels of supporting institutions: private banks, corporate investments) the numerous trends that effect these subgroups subsequently effect the best possible discount rate.

For example, in assessing the impact of semi-longterm phenomena such as climate change, some contend that use of any discount rate much greater than 1% per annum could cause long-term damage (as few as 50 plus years from now). The effects of this potential damage on the global market place will likely grow in relation to Carbon emissions: exponentially. While the scientifically certain progress of global climate change is not debatable, discount rates that consider climate change as an economic variable are not agreed upon in today's economic and scientific communities. Furthermore, a high discount rate is often preferred by governments attempting to stimulate an economy; a higher discount rate makes money cheaper for banks which then have greater lending power. The validity of this method for affecting market growth has been challenged, but retains its place in policy for the current US administration.

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. An estimation of the CAPM and the Security Market Line (purple) for the Dow Jones Industrial Average over the last 3 years for monthly data. ... It has been suggested that this article or section be merged with Discounted cash flow. ...

See also

• Discount window
• Discount

The discount window is an instrument of monetary policy (usually controlled by central banks) that allows eligible institutions to borrow money, usually on a short-term basis, to meet temporary shortages of liquidity caused by internal or external disruptions. ... In finance, discounting is the process of finding the current value of an amount of cash at some future date, and along with compounding cash from the basis of time value of money calculations. ...

External links

• Definition of the "Discount Rate" from the Federal Reserve Board's official site
• Instruments of the Money Market: Table of Contents
• The Discount Rate and Theories of the Great Depression, R. L. Norman, Jr.
• Instruments of the Money Market: Chapter 3 - The discount window
• Using the Build Up procedure for equity discount rate calculation.