Discount rate

Before you rely on it

What to check

State the rate you used and where it came from, then run the answer above and below it.

The common error

Where people go wrong with discount rate

Presenting one number from one rate. A conclusion that survives only at a single carefully chosen discount rate is not a conclusion, and it will not survive contact with anybody who asks a second question.

Worked through

Discount rate in plain numbers

What is $10,000 arriving in five years worth today? At a 6% discount rate the present value is $10,000 ÷ 1.06⁵, which is $7,472.58. At 10% it is $6,209.21. Same future cash, very different value today, because a higher rate means you demand more return for waiting. Choosing the rate is the whole argument. A safe government bond rate suits a safe cash flow. A risky project needs a higher one. Change the rate by four points and the value of a distant payment swings by roughly a sixth.

Easily confused

Discount rate and its neighbours

The discount rate is not the interest rate on a loan, and it is not the same as the required return, though the two are close; it is the rate used to convert future cash flows to present value. It reflects the time value of money plus risk. In corporate finance it is often the weighted average cost of capital, and the discount rate at a central bank is a different thing again: the rate at which it lends to banks. Context tells which meaning applies.

In real decisions

Where discount rate turns up

Discounted cash flow valuation depends on it. So do capital budgeting decisions, net present value and internal rate of return comparisons, pension liability calculations and lease accounting. An investor valuing a stock chooses a discount rate for expected dividends or free cash flow; a city evaluating a long-lived project picks one for its costs and benefits; retirees converting a stream of payments into a lump sum use it. Whenever future money is compared with money today, a discount rate is involved.

Know the edges

Where discount rate stops being reliable

There is no single correct rate. Small changes produce large differences in long-dated values, so results are sensitive to a choice that is partly judgment. Rates change over time, and cash flows themselves are uncertain, and a low rate can make almost any project look attractive, and a high rate can kill good long-term ideas. Show the result at several rates and be explicit about the reasoning behind the base case.

Quick answers

What people ask about discount rate

How do I choose a discount rate? Start with a safe rate, then add a premium for risk. For a company, the weighted average cost of capital is a common start. For personal decisions, use what you could earn on the next best use of the money.

Why do small changes in the rate matter? Because the effect compounds with time. A payment thirty years away is far more sensitive to the rate than one due next year.