Discount Rate is the rate used to calculate present value of future cash flows . It is rate which depends on the risk free rate and risk premium of an investment.
Further, actually each cash flow stream coming from different assets can be discounted at a different discount rate. This is because of variation in risk premium which may be due to expected inflation rate, different maturity level and probability of defaults.
This can be explained with the help of term structure of interest rates. For instance in upward sloping term structure of interest rates increases with the maturity as longer maturity may mean more inflation risk , more liquidity risk or more default risk.
Though future cash flows can be discounted at different rate, one may use same discount rate to get the same present value.
In simple words, it is the interest rate used to to obtain the net present value (NPV) of future cash inflows. Further, NPV helps to decided the viability of the project or investment. Thus , this rate decides the profitability of the project.
If NPV is positive project is viable (i.e. profitable) and if NPV is negative or equal than project is not profitable.
And, Net present value and discount rate have a opposite relationship i.e. higher the rate lower the NPV and vice-versa. Because , future cash inflows deduces in the value if discounted at higher interest rate.
What is the formula for discounted rate and net present value?
Following formula is used for computing discounting rate and net present value:
Discount rate =(Future cash flow/Present cash flow)1/n -1
Whereas n = number of years
Net present value (NPV) = CF/(1+r)n
- Where, n= number of years of cash flow in future
- r= discount rate
- CF= Projected cash flow of the year
Example of discount rate
Cash flows and discounted rates for each year of cash flows at different maturities have been given as below:
| 1st year | 2nd year | 3rd year | 4th year | 5th year | |
| Cash Flows | ₹100 | ₹200 | ₹300 | ₹400 | ₹500 |
| 2.0% | 3.2% | 3.6% | 4.8% | 5.0% |
The present value of this stream of cash flows , by discounting each flows with the respective rate is ₹ 1,278.99.
The single rate equates the present value of the stream of cash flows to approximately ₹ 1,278.99 at 4.4861%.
Conclusion:
- Discount rate used to to obtain the net present value (NPV) of future cash inflows.
- NPV helps to decided the viability of the project or investment. Thus , this rate decides the profitability of the project.
- If NPV is positive project is viable (i.e. profitable) and if NPV is negative or equal than project is not profitable.
Refer: https://taxandfinanceguide.com/internal-rate-of-return-irr/
