In finance, the discount rate is the rate used in present value calculations.
The concept of present value is one of the most foundational concepts in finance, as it allows investors to quantify a future payment in today’s dollars (or euros, yen, etc.). Investors use present value calculations (called discounting) to estimate the value of stocks, bonds, real estate, and any other asset that is expected to provide future cash flows.
The discount rate is one of three variables used in present value calculations, the others being the number of years and the number of discounting periods in each year.
It is important that investors use a discount rate that reflects the risk of a given investment. In other words, the riskier the investment is, the higher the discount rate that should be used in present value calculations. Investors calculate the discount rate by adding an appropriate risk premium to the risk-free rate. The risk-free rate is usually the rate on short-term government bonds.
Using a higher discount rate for riskier investments highlights an important characteristic of present value calculations: the present value and the discount rate are inversely related. In other words, a higher discount rate leads to a lower present value and a lower discount rate leads to a higher present value.
To see the impact of the discount rate on present value, consider an investment that is expected to pay $10,000 in one year. If we use a 5% discount rate, then the present value of this investment is $9,524. However, if we use a 10% discount rate, the present value is $9,091.