Definition
The discount rate is the interest rate used in discounted cash flow (DCF) analysis to determine the present value of future cash flows. [1]
Purpose
The discount rate takes into account not just the time value of money, but also the risk or uncertainty of future cash flows; the greater the uncertainty of future cash flows, the higher the discount rate. Spreadsheets make it easy to calculate the appropriate discount factors.
Construction
Typically the discount rate is decided at the corporate level and has the dual purpose of compensating for both the time value of money and the risk inherent in the activity. A general principle to employ is that the riskier the project, the greater the discount rate to use.[2]
The figure above shows that a 10% discount rate applied to $1 received now and in each of the next three years reduces in value over time.
References
- ^ Investopedia. Dictionary: Discount Rate.
- ^ Farris, Paul W.; Neil T. Bendle; Phillip E. Pfeifer; and David J. Reibstein (2010). Marketing Metrics: The Definitive Guide to Measuring Marketing Performance (Second Edition). Upper Saddle River, New Jersey: Pearson Education, Inc.