Discount Rate Definition & Examples

Published Dec 26, 2022

Definition of Discount Rate

The discount rate is the interest rate used to calculate the present value of future cash flows. That means it is the rate used to determine how much a future payment is worth today. This rate is used to compare investments with different time horizons and to decide which one is more profitable.

Example

To illustrate this, let’s look at an example. Imagine you have two investments with different time horizons. The first one is a USD 1,000 bond that will mature in one year and pay USD 1,100. The second one is a USD 1,000 bond that will mature in two years and pay USD 1,200. To decide which one is more profitable, you need to calculate the present value of each bond. To do that, you need to use a discount rate.

Let’s assume the discount rate is 5%. That means the present value of the first bond is USD 1,047.62 (i.e., 1,100 / (1 + 0.05)). Similarly, the present value of the second bond is USD 1,088.44 (i.e., 1,200 / (1 + 0.05)²). As a result, the second bond is more profitable than the first one.

Why Discount Rate Matters

The discount rate is an essential concept for making investment decisions. It helps investors compare investments with different time horizons and decide which one is more profitable. It also helps them to decide whether an investment is worth the risk or not. Finally, it is also used to calculate the present value of future cash flows, which is essential for financial planning.

Disclaimer: This definition was written by Quickbot, our artificial intelligence model trained to answer basic questions about economics. While the bot provides adequate and factually correct explanations in most cases, additional fact-checking is required. Use at your own risk.