discount rate

(noun)

The interest rate used to discount future cashflows of a financial instrument; the annual interest rate used to decrease the amounts of future cashflows to yield their present value.

Related Terms

Examples of discount rate in the following topics:

  • Factors Affecting the Price of a Bond

    • A bond's book value is affected by its term, face value, coupon rate, and discount rate.
    • To calculate the present value, each payment is adjusted using the discount rate.
    • The discount rate is a measure of what the bondholder's return would be if he invested his money in another security.
    • In practical terms, the discount rate generally equals the coupon rate or interest rate associated with similar investment securities.
    • Explain how a bond's value is affected by its term, face value, coupon and discount rate

  • Bond Valuation Method

    • The bond's contract rate is another term for the bond's coupon rate.
    • The market rate is what other bonds that have a similar risk pay in interest.
    • If the market rate is greater than the coupon rate, the bonds will probably be sold for an amount less than the bonds' face value and the business will have to report a "bond discount. " The value of the bond discount will be the difference between what the bonds' face value and what the business received when it sold the bonds.
    • If the market rate is less than the coupon rate, the bonds will probably be sold for an amount greater than the bonds' value.
    • The discount rate for both the principal and interest payment components is the market rate when the bond was issued.

  • Issuing Bonds

    • The more risk assessed to a company the higher the interest rate the issuer must pay to buyers.
    • If a bond has a coupon interest rate that is higher than the market interest rate it is considered a premium.
    • The premium (higher interest rate) is to offset the assumed higher than average risk associated with investing in the company.
    • Bonds are considered issued at a discount when the coupon interest rate is below the market interest rate.That means a company selling bonds at a discount rate receive less than the face value of the bond in the sale.

  • Bonds Issued at a Discount

    • Assume a business sells a 10 year, $100,000 bond with an effective annual interest rate of 6% for $90,000.
    • The journal entry for that transaction would be as follows: Cash $90,000 Discount $10,000 Bond Payable $100,000The interest expense each period is $6,000, and the amortization rate on the bond payable equals $1,000 ($100,000/10 years).
    • When a bond is sold at a discount, the market rate of the bond exceeds the contract rate.
    • Generally, the amortization rate is calculated by dividing the discount by the number of periods the company has to pay interest.
    • That means that the amortization rate on the bond payable equal $1,000 ($100,000/10 years).

  • Valuing Zero-Coupon Bonds

    • The value of a zero-coupon bond equals the present value of its face value discounted by the bond's contract rate.
    • If the effective interest rate is 7%, what are the proceeds?
    • The discount is a contra-liability linked to the bond payable; this yields a net bond payable of 81,629.79, the bond payable less the discount.
    • Zero-Coupon Bond Value = Face Value of Bond / (1+ interest Rate)
    • If the interest rate of the bond is expressed as a monthly rate and the term of the bond is 10 years, the bond term should be expressed as 120 months when making the calculation.

  • Additional Factors to Consider

    • Finally, the valuator needs to consider the discount or capitalization rate of the company, specify what percentage of the company is being valued, and take into account any marketability or minority interest discounts.

  • Bonds Issued at a Premium

    • This would make the amortization rate of the bond's premium equal to $1,000 per year.
    • This generally means that the bond's contract rate is greater than the market rate.
    • Like with a bond that is sold at a discount, the difference between the bond's face value and sales price must be amortized over the term of the bond.
    • However, unlike with a bond sold at a discount, the process of amortizing the premium will decrease the bond's interest expense recorded on the issuing company's financial records.
    • The company must debit the bond premium account by the amortization rate.

  • Bonds Issued at Par Value

    • Consider a 3-year bond with a face value of $1,000 and an effective interest rate of 7%, sold at face value.
    • This generally means that the bond's market and contract rates are equal to each other, meaning that there is no bond premium or discount.

  • Types of Bonds

    • These bonds have a stipulated conversion rate of some number of shares for each USD 1,000 bond.
    • These are high-interest rate, high-risk bonds.
    • Also known as FRNs or floaters, these have a variable coupon that is linked to a reference rate of interest, such as LIBOR or Euribor.
    • They are issued at a substantial discount to par value, so that the interest is effectively rolled up to maturity (and usually taxed as such).
    • It is characterized as the safest bond, with the lowest interest rate.

  • Redeeming at Maturity

    • For a bond sold at discount, its carrying value will increase and equal their par value at maturity.
    • Some structured bonds can have a redemption amount that is different from the face amount and can be linked to performance of particular assets such as a stock or commodity index, foreign exchange rate or a fund.
    • All bond discounts and premiums also appear on the balance sheet.
    • A description of bonds issued including the effective interest rate, maturity date, terms, and sinking fund requirements are included in the notes to financial statements.