What is the discount rate used for?

The discount rate is the interest rate that is used to bring future financial flows to their current value. Its calculation, perhaps, is one of the most pressing and complex issues that arises from the financial evaluation of any investment project. From its correctness depends, what final value the current monetary value will have.

If we apply a low rate, the discounted value of the expected future cash inflows may be overestimated. This will entail the investor choosing an inefficient project, as a result of which he will suffer serious losses. An excessively high rate, in turn, can lead to losses, which in fact are a lost opportunity to generate income.

The discount rate, therefore, is the rate of return in percent, which the investor should receive on invested capital. That is, a project for an investor is considered attractive when the rate of return for it is higher than the discount rate of any other possible investment of capital having a similar risk.

The discount rate, on the other hand, is a reflection of the value of money , taking into account the risks and time factor, since the real money that people have at the moment is much preferable (they have a higher cost) to the amount of money that it expects to receive in the future.

This is due to several reasons, for example, that:

• There is always a risk of simply not getting the expected amount;

• The available amount could make a profit, say, being deposited with a bank.

• The available amount as a result of inflation will lose its purchasing power.

The following parameters are included in the discount rate:

• Rates of inflation ;

• Investment risk ratio (for each specific case);

• Minimum level of profitability, which can be guaranteed.

The discount rate, calculated on the basis of various methods, is often determined experimentally in practice. At the same time, both the requirements of the investor and of the investment bank that attracts the funds required for the implementation of the project are taken into account.

Under Russian conditions, investment activity is always associated with a variable level of risk, hence, with constantly changing levels of income and expenditure. For this reason, in practice, the profitability of the project is rarely calculated using the direct capitalization method, without considering the discount rate.

The method of discounting financial flows, taking into account discounting, certainly, much more accurately reflects the available value of revenues.

The most common methods for determining the discount rate for financial flows of capital include the following models:

1. For your own:

• Valuation of capital assets;

• Cumulative construction.

2. For investment:

• Weighted average cost of capital.

The principal point in the process of discounting is the setting of a certain discount rate. From an economic point of view, the discount rate is the rate of return that could be obtained if these funds were available to the organization. With the help of the discount rate determine the amount that the investor will have to pay today in order to have the right to receive the expected amount in the future.

The discount rate is necessary to:

• Make a more accurate calculation of project profitability;

• Compare the received indicators of the existing project with the lowest rate of return when investing in a similar business.