discount rate

Examples of discount rate in the following topics:

• NPV Profiles

  • The NPV Profile graphs the relationship between NPV and discount rates.
  • The NPV calculation involves discounting all cash flows to the present based on an assumed discount rate.
  • When the discount rate is large, there are larger differences between PV and FV (present and future value) for each cash flow than when the discount rate is small.
  • A special discount rate is highlighted in the IRR, which stands for Internal Rate of Return.
  • It is the discount rate at which the NPV is equal to zero.

• Risk Adjusting the Discount Rate

  • The discount rate has a few definitions, depending on the context.
  • The primary purpose of a discount rate, or an interest rate in general, is fairly simple.
  • It is at this point that the logic behind adjusting discount rates becomes practical.
  • With this increase in risk, the discount rate can now be risk-adjusted accordingly.
  • This chart illustrates the devaluation of capital over time as a result of various discount rates.

• Calculating the NPV

  • The other integral input variable for calculating NPV is the discount rate.
  • There are many methods for calculating the appropriate discount rate.
  • Since many people believe that it is appropriate to use higher discount rates to adjust for risk or other factors, they may choose to use a variable discount rate.
  • Reinvestment rate can be defined as the rate of return for the firm's investments on average, which can also be used as the discount rate.
  • The payments are discounted using a selected interest rate, signified by the i variable.

• The Discount Rate

  • The interest rate, in this context, is more commonly called the discount rate.
  • The discount rate represents some cost (or group of costs) to the investor or creditor.
  • All of these costs combine to determine the interest rate on an account, and that interest rate in turn is the rate at which the sum is discounted.
  • If FV and n are held as constants, then as the discount rate (i) increases, PV decreases.
  • To determine the present value, you would need to discount it by some interest rate (i).

• Yield to Maturity and Rate of Return

  • Investors who purchased a financial security know the face value, the maturity date, number of interest payments per year, and the amount of interest payments.However, investors do not know the discount rate.They can substitute the information into the present value formula and solve for the discount rate.Then investors can calculate the discount rate for several different bonds and select the bond that has the highest discount rate.
  • If investors hold the bond until maturity, then we call the discount rate the yield to maturity.Economists consider yield to maturity the most accurate measure of the interest rates because the yield to maturity allows investors to compare different bonds.For example, you want to buy a coupon bond today for a market price of $1,600.Bond pays $400 interest per year and matures in three years.Finally, the bond pays $1,000 on the maturity date.Consequently, we calculate your yield to maturity of 14.11% in Equation 6.You can compare this yield toother investments and choose the investment with the greatest yield.
  • As you can see, this calculation becomes very complicated.If you calculate the discount rate manually, then you must calculate the PV0 by selecting various discount rates, such as 0%, 5%, 10%, and 20%.Next, you insert your particular discount rate, r, into the Equation 7, and select the discount rate that has a present value, PV0 close to $1,600.Mathematicians wrote programs that can solve for the discount rate.If you visit the author's website, www.kenszulczyk.com, he has a JavaScript program that can solve for the discount rate.
  • Market interest rate (or yield to maturity) and the market price (or present value) of the securities are inversely related.For example, if you examine the present value formula, the interest rate, or yield to maturity is located in the denominators of the fractions.Thus, the market price falls as the interest rate rises, and vice versa.
  • You can become confused by the terms used throughout this book.We use yield to maturity, discount rate, and interest rate interchangeably, and you can interpret these terms to mean an interest rate.However, a rate of return differs because investors could sell their securities before they matured.Thus, the rate or return includes the interest rate and capital gains or losses.A capital gain is an investor sells a financial security for greater price, while a capital loss is an investor sells a financial security for a lower price.Investors do not want capitallosses, but they can occur.For instance, an investor must sell an asset whose market price has dropped because he or she needs cash quickly.Thus, the present value still works for capital gains and losses.Finally, if the investor holds onto the security onto the maturity date, then the rate of return equals the yield to maturity.

• Present Value of Payments

  • The value of a bond is obtained by discounting the bond's expected cash flows to the present using an appropriate discount rate.
  • Therefore, the value of a bond is obtained by discounting the bond's expected cash flows to the present using an appropriate discount rate.
  • In practice, this discount rate is often determined by reference to similar instruments, provided that such instruments exist.
  • The formula for calculating a bond's price uses the basic present value (PV) formula for a given discount rate .
  • The present value of an annuity is the value of a stream of payments, discounted by the interest rate to account for the payments being made at various moments in the future.

• Discount Policy

  • The $1,000 difference reflects the interest rate the Fed charges for the loan, called the discount rate.
  • The Fed could use the discount rate for expansionary monetary policy.
  • For example, the Fed raises the discount rate.
  • For example, the Fed raises the discount rate.
  • The Federal Reserve uses the discount rate to decrease money supply

• Discounted Payback

  • Discounted payback period is the amount of time to cover the cost, by adding positive discounted cash flow coming from the profits of the project.
  • Assuming the discount rate is 10%, we would apply the following formula to each cash flow.
  • The next step is to compute the cumulative discounted cash flow, by summing the discounted cash flow for each year.
  • Bundesbank discount interest rates from 1948 to 1998.
  • The vertical scale shows the interest rate in percent and the horizontal scale shows years.

• Discounted Cash Flow Approach

  • A discounted cash flow analysis is a highly useful tool for calculating the net present value of a given product, process, asset, or organization.
  • NPV analyses using the discounted cash flow approach are widely used across various industries to decide which projects to invest in.
  • The inputs for a discounted cash flow analysis are:
  • r - The interest rate or discount rate, which reflects two important pieces of information: the opportunity cost of foregoing other investments as well as the intrinsic risk of not receiving the projected cash flow.
  • As a result, determining 'r' (required rate of return due to opportunity cost and risk) is absolutely critical to the success of these calculations.

• Discounted Dividend vs. Corporate Valuation

  • The dividend discount model values a firm at the discounted sum of all of its future dividends, and does not factor in income or assets.
  • The dividend discount model (DDM) is a way of valuing a company based on the theory that a stock is worth the discounted sum of all of its future dividend payments.
  • g is the constant growth rate in perpetuity expected for the dividends.
  • a) The presumption of a steady and perpetual growth rate less than the cost of capital may not be reasonable.
  • c) The stock price resulting from the Gordon model is hypersensitive to the growth rate chosen.