What is a 'Discount Rate'
The interest rate charged to commercial banks and other depository institutions for loans received from the Federal Reserve Bank’s discount window. The discount rate also refers to the interest rate used in discounted cash flow (DCF) analysis to determine the present value of future cash flows. The discount rate in DCF analysis takes into account not just the time value of money, but also the risk or uncertainty of future cash flows; the greater the uncertainty of future cash flows, the higher the discount rate. A third meaning of the term “discount rate” is the rate used by pension plans and insurance companies for discounting their liabilities.
BREAKING DOWN 'Discount Rate'
The Fed’s Discount Rate is an administered rate set by the Federal Reserve Banks, rather than a market rate of interest. Use of the Fed’s discount window soared in late 2007 and 2008, as financial conditions deteriorated sharply and the Federal Reserve took steps to provide liquidity to the financial system. Discount window borrowing soared to a record $111 billion at the height of the global financial crisis in October 2008, while the Federal Reserve’s board of governors set the discount rate at a post-WW II low of 0.5% on Dec. 16, 2008.
A simple explanation of the discount rate used in DCF analysis is as follows. Let's say you expect $1,000 in one year. To determine the present value of this $1,000 (what it is worth to you today), you would need to discount it by a particular interest rate. Assuming a discount rate of 10%, the $1,000 in a year's time would be equivalent to $909.09 to you today (1,000 / [1.00 + 0.10]). If you expect to receive the $1,000 in two years, its present value would be $826.45.
What is the appropriate discount rate to use for a project? Many companies use their weighted average cost of capital (WACC) if the project's risk profile is similar to that of the company. But if the project’s risk profile is substantially different from that of the company, the Capital Asset Pricing Model (CAPM) is often used to calculate a project-specific discount rate that more accurately reflects its risk.