Discount rates, also known as discount factors, refer to the interest rate used in discounted cash flow (DCF) analysis to determine the present value of future cash flows. Another meaning of the term “discount rate” is the rate used by pension plans and insurance companies for discounting their liabilities. Third system of calculating discount rate is bank discount rate. The bank discount rate is based on the instrument’s par value and the amount of the discount on short-term money-market instruments like commercial paper and Treasury bills.
The discount rates are used by investors to translate the value of future investment compared to money invested today. For example, let us assume that you expect Rs.10000/- after a year. To find out the present value (worth) of Rs.10000/- you are going to get after a year, you need to discount it at a particular interest rate. Let us assume here 10% is the discount rate. Then the value of Rs.10000 received after a year is equivalent to Rs.9990.90 and received after two years is equivalent Rs.8264.46.
How to calculate discount rate?
The formula used to calculate discount is D=1/(1+P)n
where D is discount factor, P = periodic interest rate, n is number of payments.
Calculation of Present Value after one year
= Future Value x [1/ (1.00 + 0.10)]=10000 x [0.909090]= 9090.90
Calculation of present value of Rs.10000 after two years
= Future Value x [1/ (1.00 + 0.10)2] =10000 x [0.0.826446] = 8264.46
Using above formula present value of investment can be assessed after any number of years.
In the above example if the payments are made monthly, then the periodic interest rate is (0.10/12) = 0.0083 Discount factor is 0.0083 for one year.
D=1/ (1+P)n = 1/(1.0083)24 = 1/=1/1.2194=0.8200
Discount factor would be 0.8200 for 2 years
Bank discount rate
The bank discount rate is based on the instrument’s par value and the amount of the discount on short-term money-market instruments like commercial paper and Treasury bills.
Let us take an example of a Commercial Paper of face value Rs.10000 and a purchase value of the same is Rs.9700 that matures in one year.
In the instant case discount received is 10000-9700=Rs.300
We may find out the interest rate as
(300\1000) x 100 = 3%
In the calculation of bank discount rates, whenever calculated for number of days, normally for calculation purpose one year is treated as equivalent to 360 days (1 year=360 days)
- What is capital budgeting?
- What are NPV, IRR, DCF, Hurdle rate, Accounting rate of return in capital budgeting?
- What is Benefit to cost ratio?