In finance, the discount rate has different meanings, some important ones mentioned below:
- Discount rate refers to the rate of interest charged by the central bank from the depository institutions which borrow reserves form it, for instance, for the use of discount window of the Federal Reserve.
- Discount rate can be explained as the interest rate where the term “discount” does not implicate to its common meaning. It is rather an implication of the calculations of present value, like NPV or DCF.
- The discount rate, sometimes also referred as the annual effective discount rate, can be defined as the annual interest divided by the capital plus that interest. This rate is lower than rate of interest. Moreover, it corresponds to the use of value after a year in the form of a nominal value less a discount. Also, it is used for treasury bills and comparable financial instruments.
As per Investopedia, the discount rate is determined through the average rates which are willingly charged by the banks from each other for overnight funds. The interest rates used in discounted cash flow analysis for determining the present value of future cash flows. Besides, the discount rate also takes into consideration the time value of money as well as the uncertainty or risk of the expected cash flows in a manner as explained below:
1. The time value of money
As per the theory of time preference, the investors would prefer to have cash instantly rather than waiting and should, therefore, essentially be compensated for the delay by being paid for the same.
2. The risk level
The discount rate reflects the extra return demanded by the investors so that they can be compensated for the risk which might not have been materialized by the cash flow.
A business needs to think about the discount rate while deciding about whether to spend a part of the profits on purchasing a new piece of equipment or to give back the profit to their shareholders. Idyllically, they would prefer to buy a new piece of equipment if a higher amount of profit for shareholders is expected by the same in near future.