Discount rate

The discount rate is the interest rate that firms use to determine how much a future cash flow is worth in the present. The practice of using the discount rate to evaluate cash flows is called discounting

Using the discount rate, the calculation finds the present value:

Present value = [math]\frac{Future\ Value\ After\ t\ Periods}{(1+r)^{t}}[/math]

• [math]t[/math] = Period of time measured in years
• [math]r[/math] = The discount rate (interest rate) expressed as a decimal
• The future value after the whole period of time ([math]t[/math])

If the future value after one year is $10,500 and the discount rate is 5% then:

Present value = [math]\frac{10,500}{(1.05)^{1}}[/math]

Present value = $10,000

If a consumer wants to save their money to earn interest so they can buy a new TV in 2 years, then they can use the price of the TV ($2,500, assuming it does not change) and find out how much money they need to save at 7% interest:

Present value = [math]\frac{2,500}{(1.07)^{2}}[/math]

Present value = $2,183.59

If they put $2,183.59 away at 7% interest over 2 years then they will have the right amount of money to buy the TV they want.

See Also

• Discounting
• Time value of money