Discount rate is a crucial concept in finance and could mean two things. First, is in reference to the interest rate that the central banks charge commercial banks and other financial institutions. Second, is the rate that one uses in the discounted cash flow (DCF) analysis and other things to determine the present value of the future cash flows.
Discount Rate Used by Central Banks
Commercial banks borrow money for short-term operating requirements from the central bank or the Federal Reserve Bank in case of the US. The bank uses such loan for funding shortfalls, address any liquidity issue and more.
Such a facility is known as discount window, and the funds are generally given for 24-hours or less. The interest rate that the central bank charges on such loans are the discount rate. It is not the market rate, rather it is set by central bank mostly, and thus, serves as a benchmark for other interest rates in the economy.
Commercial banks use such a facility rarely as the interest rate is relatively higher than the interbank borrowing rates. Moreover, borrowing from the central bank could also signal weakness to the investors and others in the market. Use of discount window, however, rises during times of financial stress. For instance, during the 2007-2008 financial crisis, demand for Fed’s discount window was very high.
Comes in Three Tiers
Fed’s discount window program comes in three tiers. The first is the primary credit program, and it focuses on offering capital to “financially-sound” banks. Fed sets the discount rate for this program above the existing market interest rates.
The second tier is the secondary credit program, and it extends to institutions that do not qualify for the first program. The interest rate is set 50 basis points above the primary rate. Financial institutions qualifying for this tier are usually smaller and may not be much financially sound.
Fed’s third tier is the seasonal credit program, which extends to smaller financial institutions with higher volatility in the cash flows. For instance, financial institutions serving agriculture or tourism sectors see fluctuations in their cash flows due to their seasonal patterns. However, their cash flows are predictable depending on the weather conditions. But, institutions in this tier are riskiest, and thus, face higher interest rate.
The discount rate for the first two tiers is set independently by the Fed irrespective of the market rates. For the third tier, the rate is in accordance with the prevailing rates in the market.
Discount Rate For Calculating Present Value
Another meaning of discount rate in the finance world is the rate of return that analysts use to discount the future cash flows to the present value. Or, it is the rate of return that an investor expects to earn on an investment. This rate is usually the Weighted Average Cost of Capital (WACC) or the required rate of return.
For instance, an investor has $10,000 to invest, but want a return of at least 7% over the next five years. In this case, 7% is the discount rate or is the return that an investor wants in exchange for the investment.
One can say, the concept of discount rate is similar to the compound growth. Under the compound growth, the initial investment is put to work and it earns interest to increase the investment value. Similarly, for discounting, the discount rate becomes the expected rate of return or the rate to discount the future cash flows. Or, we can say discounting is the opposite of growing.
Where it is Useful?
- Helps in the calculation of the Net Present Value (NPV) while doing a Discounted Cash Flow (DCF) analysis. A DCF analysis is a useful tool to determine the potential value of a business or an investment. A slight variation in the discount rate can make a big difference in the DCF result. A general rule is that as the rate moves higher, the investment becomes less valuable.
- For calculating the time value of money. For instance, $100 now won’t be able to purchase the same amount of goods in the future. Suppose you earn $1000 per month now, but if your boss says, your salary would be $3000 in three years, should you be happy? You can check this by calculating the time value of money.
- To calculate the opportunity cost for a firm.
- Determine the riskiness of an investment. Discount rate factors the loss of money for an investor owing to inherent risks. So, one discounts the cash flow to compensate for the losses that can happen to an investment.
- Compare different investments.
- To compute what the investment will be worth in the future.
- To calculate the amount that one must invest now to meet the future investment goal.
Types of Discount Rates
Weighted Average Cost of Capital (WACC)
The analyst usually uses WACC to calculate the enterprise value of a firm. It is a combination of cost of equity and the cost of debt. Most companies use WACC as an alternative to the cost of capital as it is the minimum return that the company wants. A company must only invest in projects that generate returns more than the WACC.
Cost of Equity
It is useful for calculating the equity value of a firm.
Cost of Debt
One uses this for calculating the value of a bond or fixed-income security. The rate that one uses to discount bonds is also called the yield to maturity (YTM) or the return on the bond that is purchased now and held till maturity.
For investing in standard assets, such as treasury bonds, the risk-free rate comes in place of the discount rate.
Issues with Discount Rates
Use of discount rate in the financial tools may appear scientific, but it is not. Several assumptions go in for estimating or calculating this rate. Also, a company or analyst generally uses one discount rate for all future cash flows. This is not as practical as risk profiles and interest rates are constantly changing.