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[1][2]
Using the discount rate, the calculation finds the present value:
- Present value =
- Present value =
- t = Period of time measured in years
- r = The discount rate (interest rate) expressed as a decimal
- The future value after the whole period of time (t)
If the future value after one year is $10,500 and the discount rate is 5% then:
- Present value =
- Present value =
- 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 =
- Present value =
- 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
References
- ↑ R. A. Brealey et al. Fundamentals of Corporate Finance. Toronto: McGraw-Hill Ryerson, 2012, pp. 85.
- ↑ Investopedia. "Discount Rate." [Online], Available: http://www.investopedia.com/terms/d/discountrate.asp?ad=dirN&qo=investopediaSiteSearch&qsrc=0&o=40186 [Aug 30, 2016].