Glossary
Discount Rate
A discount rate is the rate of return used to convert future cash flows into present value. It reflects the time value of money and the risk of the cash flows: riskier or later cash flows get a higher rate and a lower present value. It is central to NPV and DCF valuation.
Formula
Example
An investor expects to receive $1,000,000 in five years. At an 8% discount rate, the present value is $1,000,000 / 1.08^5 = $1,000,000 / 1.4693 = about $680,583. At a 12% discount rate, the present value is $1,000,000 / 1.12^5 = $1,000,000 / 1.7623 = about $567,427. Raising the rate by four percentage points reduces today's value by about $113,000.
How it is used in underwriting
Choosing the discount rate is a judgment about risk and opportunity cost. For a company, underwriters typically use WACC to discount unlevered cash flows; for equity cash flows, they use the cost of equity or an investor's target return; for a real estate DCF, they use a market-derived rate that reflects the property type and location. The discount rate should match the cash flows it is applied to: nominal with nominal, levered with levered, after-tax with after-tax. Mismatches are one of the most frequent errors in valuation models.
The term has other meanings worth distinguishing. Central banks set a discount rate for lending to banks, which is unrelated to valuation. In real estate, the discount rate used in a DCF differs from the cap rate: the discount rate is a total return requirement, while the cap rate is a current yield, and the difference roughly reflects expected income growth. In insurance and structured credit, discount rates are applied to expected future losses or cash flows to price risk. Whatever the setting, small changes in the rate can swing value substantially, so sensitivity analysis is essential.
Frequently asked questions
What is the difference between a discount rate and an interest rate?
An interest rate is the cost of borrowing or the return on a specific loan. A discount rate is the rate used to calculate present value, which may be based on an interest rate, a cost of capital or a target return. Discount rates usually include a premium for the risk of the cash flows being valued.
Is the discount rate the same as the cap rate?
No. A discount rate is a total required return used to discount multi-year cash flows. A cap rate is a single-year income yield used to value a property from one year's NOI. In simplified terms, the cap rate roughly equals the discount rate minus the expected long-term growth rate of income.
Why does a higher discount rate lower value?
A higher discount rate means each future dollar is worth less today, either because money has a higher opportunity cost or because the cash flow is riskier. Since present value divides future cash by one plus the rate raised to a power, raising the rate reduces present value, and the effect is larger for distant cash flows.
Related terms
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