Discount rate is the interest rate that is used in order to determine the present value of future cash flows. The concept of discount rate varies from that of the interest rate. The relation between the discount rate and interest rate can be expressed by the following mathematical formula.
For every interest rate, there is a corresponding discount rate, given by the following formula:
d = i / (1+i)
i = d / 1-d
here d stands for the discount rate
and i stands for the interest rate
The concept of discount rate can also be defined in an alternative way. The discount rate also tells that how future value is principal and how much is the interest. A mathematical example can make the concept of discount rate even clearer.
For example, if an amount of $100 is deposited at the interest rate of 50%, the future amount that comes out is equal to $150.
The discount rate is very often expressed as an annual rate. The cash flow�s discounted value is determined by reducing the value by the discount rate for each time unit. The discounted cash flow actually follows the normal calculation of interest but not that of discount rate.
The use of appropriate discount rate under the required circumstances is one of the major concerns discussed in economics. For example, if we want to assess the long-term impact of climate-change phenomena, the use of more than 1% discount rate per annum may cause long-term damage. Hence, we can conclude that the discount rates for climate change give uncertain result and are not useful in today’s economic community.
On the other hand, the governments generally apply discount rates of perhaps 20% per annum because anything they do or fail to do causing detrimental effects, probably in the coming 10 or more years, won’t prevent their re-election. Usually discount rates such as 2%, 3%, 5% and 10% are hugely used in economics, though there is little agreement on appropriate value to be used in a given circumstance, which generally makes a substantial difference.
Last Updated on : 1st July 2013