Discount rate

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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 = [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

References

  1. R. A. Brealey et al. Fundamentals of Corporate Finance. Toronto: McGraw-Hill Ryerson, 2012, pp. 85.
  2. "Routledge Dictionary of Economics", discount rate, published Routledge Press, 2013. Edited by Donald Rutherford Online version accessed [August 17th, 2017].

Authors and Editors

Lyndon G., Jason Donev
Last updated: August 29, 2017
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