Skip to content
Log in
← Glossary

discount rate

The annual rate used to convert future cash flows into today's money. It reflects what the money could earn elsewhere at similar risk.

The discount rate is the annual rate used to turn future cash into today's money. It answers one question: what could this money earn elsewhere at a similar risk? A company usually starts from its cost of capital, what lenders and owners expect, and sets a higher rate (a hurdle rate) for riskier bets such as a new market.

Each year's cash is multiplied by a discount factor, 1 ÷ (1 + r)ᵗ. At 25% a year the factors are 0.8, 0.64, 0.512 and 0.4096 for years 1 to 4: a hryvnia four years out is worth about 41 kopiykas today. The higher the rate, the faster later years shrink, so a high rate favors bets that pay back early and penalizes long tails.

The rate is a choice, not a fact, and it often moves the answer more than any detail of the forecast. Write it next to every present value and NPV, use the same rate for options of the same risk, and keep it for pricing risk: doubts about the forecast itself belong in the cash flows or in scenarios. Mind the period too: 2% a month is 1.02¹² − 1 = 26.82% a year, not 24%.

Example

A tools vendor promises Klasna a saving of 400,000 UAH a year for three years and calls it "1.2 million of savings". At Klasna's 25% the discount factors are 0.8, 0.64 and 0.512:

400,000 × (0.8 + 0.64 + 0.512) = 400,000 × 1.952 = 780,800 UAH today.

At the 12% a deposit pays, the same savings are worth 357,142.86 + 318,877.55 + 284,712.10 = 960,732.51 UAH. Nothing in the forecast changed, only the rate, and the value moved by 179,932.51. That's why the rate goes next to the number: "780,800 at 25%", not just "780,800".

Common mistakes

  • Taking whatever rate is at hand. A deposit rate or inflation is the floor for idle cash, not the rate for a risky product bet.
  • Mixing monthly and annual rates. 2% a month compounds to 26.82% a year; discount monthly cash flows with a monthly rate.
  • Raising the rate because the forecast feels optimistic. The rate prices risk; fix doubtful numbers in the cash flows or with scenarios.
  • Picking the rate that gives the wanted answer. Options of the same risk get the same rate, set before the numbers are in.
  • Leaving the rate out of the summary. A present value without its rate can't be checked or compared.

Learn it in the course