What is a discount rate?
You use a discount rate when estimating the attractiveness of an investment. You apply it to calculate the future value of a company in today's money. This is called discounted cash flow (DCF) analysis.
Where have you heard about discount rates?
You may have heard about discount rates in relation to discounted cash flow (DCF) analysis or to inflation. Inflation causes tomorrow's cash flow to be worth less than today's. Therefore you need to apply a discount rate in your analysis to get a true sense of a company's worth in the future, the time value of money and the risk of future cash flows.
What you need to know about discount rates.
When thinking about discount rates, it's always worth remembering the old proverb: 'a bird in the hand is worth two in the bush'. You can't predict what will happen to a company in the years ahead, including unforeseen drops in earnings, and the riskier the project, the higher the discount rate.
For example: Assuming a discount rate of 10%, the £1,000 in a year's time would be equivalent to £909.09 to you today (1,000 / [1.00 + 0.10]). If you expect to receive the £1,000 in two years, its present value would be £826.45.
And while money that's available today carries no risk and can be invested instantly to get a return, you can't invest money you don't have yet, which makes it less valuable.
But remember a discount rate is a calculated theoretical rate. Its accuracy depends on the accuracy of cash flow forecasts and predicted inflation.
Find out more about discount rates.
To learn how to work out a discount rate, watch this video.
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