The Discount rate is an interest rate a Central Bank charges depository institutions that borrow reserves from it. Discount rate is calculated on the basis of future cash flow. We will also depict the mathematical expression of discount rate.
In the United States of America, the commercial banks are charged at the discount rate on their loans provided by the Federal Reserve Bank. The Fed offers discount rate through several channels like, secondary credit, seasonal credit and primary credit. Under primary credit, loans are usually extended for a short span of time for those depository institutions that has been maintaining a sound financial growth whereas; secondary credit is provided to the small institutions.
The discount rate used is generally the appropriate Weighted Average Cost of Capital (WACC), which reflects the risk of the cash flows. The discount rate reflects two things:
- The time value of money (risk-free rate) - According to the theory of time preference, investors would rather have cash immediately than having to wait and must therefore be compensated by paying for the delay.
- A risk premium – It reflects the extra return investors demand because they want to be compensated for the risk that the cash flow might not materialize after all.
An alternative to including the risk in the discount rate is to use the risk free rate, but multiply the future cash flows by the estimated probability that they will occur (the success rate). This method, widely used in drug development, is referred to as rNPV (risk-adjusted NPV), and similar methods are used to incorporate credit risk in the probability model of CDS valuation.
Discount Rate Formula:
Discount rate (d) can be mathematically depicted as follows:
This formula is used to calculate “Principal Future Value” and, how much future value is will be taken as interest.
In other way it can be calculated as:
n = no. of years,
P = Present value of cash flow
Here, the divisor is the resultant future value of cash flow.
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 buy 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 (CAPM). Businesses normally apply this discount rate to their decisions about purchasing equipment by calculating the net present value of the decision.
Last Updated on : 23rd June 2015