Discount Rate
The interest rate used in a discounted cash flow (DCF) analysis to translate future cash flows into their value today. A higher discount rate produces a lower present value.
Key takeaways
- In DCF analysis, the discount rate is used to calculate the present value of expected future cash flows.
- A higher discount rate reduces the present value of future cash flows; a lower rate increases it.
- The right rate to use depends on the project - common choices include the risk-free rate, the company's WACC, or a project-specific hurdle rate.
- (In a separate context, 'discount rate' also refers to the rate the US Federal Reserve charges banks at its discount window - not relevant to project finance.)
In plain English
A pound today is worth more than a pound in ten years. The discount rate is the maths that converts those future pounds back into today's pounds, so you can compare them on equal terms.
If you discount £110 received one year from now at 10%, you get £100 - meaning that £110 in a year is worth the same to you as £100 right now. Apply the same logic to a 25-year stream of cash flows and you get the project's present value.
Picking the right rate
For a low-risk benchmark, the risk-free rate (typically a short-dated government bond yield) is used.
For a corporate project, the Weighted Average Cost of Capital (WACC) is the standard choice - it represents what the business actually pays for the money it deploys.
For a riskier or more speculative venture, a hurdle rate above WACC is set, to compensate for the additional uncertainty.
Effect on the dashboard
Raise the discount rate on the Solar ROI model and the NPV drops - every future £ of import savings and export revenue is now worth less in today's money. Lower it, and the NPV rises. The IRR is unchanged, because IRR is an output, not an input.