Abstract: In this paper we will analyze the financial concept of discount rate. It is calculated on the basis of future cash flow. In the United States of America, the commercial banks are charged at the discount rate on their loans provided by the Federal Reserve Bank. We will also depict the mathematical expression of discount rate.
In finance, discount rate is determined on the basis of future cash flow instead of the current value of cash flow. In USA, discount rate is that very interest rate at which the commercial banks are charged on loans taken from 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.
• Discount Rate Formula:
1) Discount rate (d) can be mathematically depicted by this way:
d = i/(1 + i).
Where i = interest rate.
This formula is used to calculate “principal future value” and, how much future value is will be taken as interest.
2) In other way it can be written that:
d = (F*n – P) / F*n.
Where F = future value of cash flow,
n = no. of years,
P = Present value of cash flow
Here, the divisor is the resultant future value of cash flow.
• Relation with Business World:
Businesses require the discount rate to decide if or not they spend from their profits to purchase new equipments, or if it is at all sensible to return the profit to their issue holders. The Capital Asset Pricing Model, aims to formulate the required rate of return on an asset, is used to calculate the shareholders' discount rates by using the share price data.