Discount Rate
In finance, Discount Rate can have two meanings; the first is the interest rate charged by a Central Bank for loans taken directly from them by financial institutions. The second is the interest rate used by analysts and corporate financiers to translate future cash flows back to their present-day value.
Discount Rate Explained
The Discount Rate (DR) is not a market set rate – the Central Bank sets that rate according to its requirements; it is normally higher than the rates available in the open market.
All of the Fed’s loans are collateralised, so the borrower will need to maintain the security cover of the loan it takes out.
Banks in particular use the Central Bank’s lending facility relatively infrequently, as it may indicate to the marketplace that the institution has credit problems.
In 2007-08 though, usage rose sharply as the lending market almost completely froze up, forcing the Fed (and others) to intervene heavily to support the financial system.
Discount Rate For Trading
It is important for investors and others to know what future cashflows are worth today; they will try to value those earnings streams in terms of Net Present Value (also known as DCF- discounted cashflow analysis).
This process makes allowance for the Time Value of Money and establishes methods of valuing different investment opportunities and assessing the relative riskiness of those investments, enabling a hurdle rate for decisions (those below that hurdle rate are discarded).
There are several types of Discount Rates;
- The Risk-free rate (normally cash) which accounts for the Time Value of Money.
- The Cost of Equity, used for assessing the pros and cons of an equity type investment.
- The Cost of Debt, used for bond-related investments.
- The Weighted Average Cost of Capital (WACC) used to evaluate the firm-wide effect of an investment choice.
- A pre-defined hurdle rate, below which a firm will not consider investing in a business venture.
This attempt at financial modelling is only an estimate of the likely outcome of an investment and is an output arising from a large number of assumptions, some of which may be inaccurate.
Interest rates and risk profiles are constantly changing such that a firm’s cost of equity, debt or WACC will not remain constant over long periods – what may be a valid rate today may not be in 10 years’ (or even 2 years’ time).
A small error in the discount rate used can be magnified many times over the life an investment project if it spans 20-30 years, leaving what looked initially like a good investment turning out to be a poor one.
Using the WACC as a discount rate focusses on the company’s share price Beta (a measure of historical price volatility), which is not necessarily a good indicator of how risky an investment will turn out to be in the future.