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- For the interest rate charged to banks for borrowing short-term funds directly from the Federal Reserve, see discount window.
The term discount rate has two meanings:
- the same as interest rate; the term "discount" does not refer to the meaning of the word, but to the purpose of using the quantity, such as computations of present value, e.g. net present value / discounted cash flow
- the annual interest divided by the capital including that interest; this rate is lower than the interest rate; it corresponds to using the value after a year as the nominal value, and seeing the initial value as the nominal value minus a discount; it is used for Treasury Bills and similar financial instruments
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Annual interest divided by the capital including that interest
One meaning of the term discount rate is the annual interest divided by the capital including that interest, which is the interest rate divided by 100% plus the interest rate. It it the annual discount factor to be applied to the future cash flow, to find the discount, subtracted from a future value to find the value one year earlier.
For example, suppose there is a government bond that sells for $95 and pays $100 in a year's time. The discount rate according the given definition is
The interest rate is calculated using 95 as its base:
For every interest rate, there is a corresponding discount rate, given by the following formula:
inversely,
Business calculations
Businesses need to consider the discount rate when deciding whether to spend some of their profits on buying a new piece of equipment, or whether to give the profit back to their shareholders. In an ideal world, they would only buy a piece of equipment if the shareholders would get a bigger profit later. The amount of extra profit that a shareholder requires in the future in order to prefer that the company buys the equipment rather than giving them the profit now is based on the shareholder's discount rate. There is a widely used way of estimating shareholder's discount rates using share price data. It is known as the capital asset pricing model. Businesses normally apply this discount rate to their decisions about purchasing equipment by calculating the net present value of the decision.
See also
External links
- Definition of the "Discount Rate" from the Federal Reserve Board's official site
- Instruments of the Money Market: Table of Contents
- The Discount Rate and Theories of the Great Depression, R. L. Norman, Jr.
- Instruments of the Money Market: Chapter 3 - The discount window
- Using the Build Up procedure for equity discount rate calculation.
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