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Discount Rate (Finance) Definition
The term discount rate refers to two very discreet concepts in finance.
First, the discount rate refers to the interest rate paid by the commercial banks and other depository financial houses against a loan received from the regional Federal Reserve Bank’s lending facility.
Second, when doing a discounted cash flow analysis, the discount rate refers to the interest rate used for calculating the present value of future cash flows.
A Little More on What is a Discount Rate
Discount rates are offered to financial institutions to prevent bank failure or liquidation. It is a very short-term loan granted by the Federal Reserve Bank’s 12 regional branches in cases of fund crunches.
- Note: the banks having deposits in the Federal Reserve Bank System can perform interbank borrowing administered by the federal funds rate. The discount rate is different than interbank borrowing.
There are three different discount window programs for depository institutions:
- primary credit – Primary credit programs are for the depository institutions with a sound financial condition. The loans under this program are granted for a very short term, typically overnight. It is offered to the banks and institutions with good credit rate. It is Federal Reserve’s main discount window program. Sometimes it is simply called the “discount rate”. The discount rate payable for this program is above the usual level of the short-term interest rate of the market.
- secondary credit – Secondary credit is for the banks with severe financial crisis or liquidity issues who do not qualify for the primary credit. The discount rate in this program is above the rate of primary credit.
- seasonal credit – Seasonal credit is offered to the smaller depository institutions having repeated intra-year fluctuation in the need of funds. The rate is an average of selected market rates. Banks serving the agricultural communities or seasonal resort communities are generally the ones getting seasonal credit.
Each of these windows has their own interest rate. The boards of Federal Reserve Banks determine the discount rate, and the Board of Governors approves the rate.
All the branches of the Reserve Bank offer the same rate for these programs except on the days when there is a change in the rate.
Discounted Cash Flow Analysis
In discounted cash flow analysis, the interest rate used for computing the present value of cash flow is called the discount rate. It is a useful tool for investors to find out the potential value of a company of investment with an expected future cash flow.
For example,iIf the discount rate is 10% the present value of $1,000 from one year now would be $1000/ (1+0.1)^1 = $909.09. In two years, it would be $1000/(1+0.1)^2 = $826.45.
- Note: The pension plans and insurance companies’ discount rate of their liabilities are also called the discount rate.
References for Discount Rate
Academic Research on Discount Rate
- · Two DCF approaches for valuing companies under alternative financing strategies (and how to choose between them), Inselbag, I., & Kaufold, H. (1997). Journal of Applied Corporate Finance, 10(1), 114-122. This piece offers a sequel to the authors’ 1989 work. Two different approaches are offered regarding ways to value debt-financed transactions using discounted cash flow methods. The practicality of both approaches are examined, giving the reader a roadmap to finding the best method depending on their desired results.
- · Survey and analysis of capital budgeting methods used by multinationals, Oblak, D. J., & Helm Jr, R. J. (1980). Financial Management, 37-41. This paper provides the results of a survey on the capital budgeting procedures of 58 US-based multinational firms. The survey was conducted in 1979, and these results are compared with a similar survey undertaken in 1966.
- · Project valuation under uncertainty: when does DCF fail?, Kulatilaka, N., & Marcus, A. J. (1992). Journal of Applied Corporate Finance, 5(3), 92-100.
- · Finance theory and financial strategy, Myers, S. C. (1984). Interfaces, 14(1), 126-137. This article explores the disconnect between the finance theory and real-world strategic planning. The author suggests that finance theory is essential to effective strategic planning.
- · The discount rate for discounted cash flow valuations of intangible assets, Schauten, M., Stegink, R., & de Graaff, G. (2010). Managerial Finance, 36(9), 799-811. This paper studies companies from the S&P 500 to find the required return on intangible assets. This method can assist in this method can assist in finding the discounted cash flow valuations of these assets. Comparisons are made to the work of Smith and Parr.
- · The optimal ordering policy in a DCF analysis for deteriorating items when trade credit depends on the order quantity, Chung, K. J., & Liao, J. J. (2006). International Journal of Production Economics, 100(1), 116-130. This paper provides a new approach that develops an inventory model for deteriorating items using the discounted cash-flows approach. Employing this method also assists in ordering practices where a payment delays are tied to order quantity.
- · How much is flexibility worth?, Copeland, T. E., & Keenan, P. T. (1998). The McKinsey Quarterly, (2), 38-50. This paper challenges the traditional notion that the net present value (NPV) method of valuation is the best way for managers to determine if a capital investment is a good move for the company. The authors offer up an alternative method, that of the real option value (ROV) method. The flexibility of this method makes it easier for managers to evaluate their potential options without experiencing unnecessary pressure.
- · The discount rate: A note on IAS 36, Husmann, S., & Schmidt, M. (2008). Accounting in Europe, 5(1), 49-62. This paper offers some explanation on the discount rate and how it’s addressed by the International Accounting Standards (IAS). The differences between generally accepted accounting principles (GAAP) and IAS are discussed. Demonstrations on the use of the discount rate are offered, and real-world applications are also presented.
- · A simple correction of the WACC discount rate for default risk and bankruptcy costs, Koziol, C. (2014). Review of Quantitative Finance and Accounting, 42(4), 653-666. This paper offers a modified version of the well-known WACC (weighted average cost of capital) approach for assisting with the standard discounted cash flows approach when considering capital investments. This new method is especially useful for firms that operate in industries with a high bankruptcy costs.
- · Cash flow and discount rate risk in up and down markets: What is actually priced?, Botshekan, M., Kraeussl, R., & Lucas, A. (2012). Journal of Financial and Quantitative Analysis, 47(6), 1279-1301. This paper takes a look at the relationship between the loss and gain preferences and how they correlate to discount rate risk versus cash flow. A model employing U.S. data illuminates these complicated interactions.
- · Inventory control and trade credit revisited, Chung, K. H. (1989). Journal of the Operational Research Society, 40(5), 495-498. This paper analyzes the discounted cash flows (DCF) approach as it relates to inventory with trade credit. Because of the effect that inventory can have on cash flows, this analysis provides a method to maximize order sizes when purchasing with delayed payments.