The discount rate is either the percentage rate used to discount future cash inflow, to compensate for present cash outflow, and arrive at project feasibility or the rate that is used for taking loans by commercial banks & other financial institutions from the Federal Reserve Bank in the discount window loan process.
It is also called a bank rate. The rate at which various banks of the country can take loans as per the monetary policy of the respective government. In India, banks can borrow money from reserve banks at the repo rate and can park funds with the RBI at reverse repo rate. RBI changes the repo rate and reverse repo rate in order to maintain liquidity in the market.
A startup will have a business model that requires cash outflow at present, with the prospect of cash inflow in the future, once the business starts operations and earns revenue. The financial feasibility (whether revenue can be earned fast enough to stay afloat or present outflow can be remedied by future turnover) is calculated using the discount rate.
For risky cash flows, the discount rate is higher. It is often used with free cash flow calculations.
The discount rate helps to assess the Net Present Value of an investment.
The higher the discount rate, the lower is net present value of the future cash flows. This implies a higher risk.
What is a Discounted Cash Flow analysis?
DCF is a type of valuation method which helps to assess the future cash flows in various years from the project. It uses the concept of the time value of money. If the net present value of all the cash flows is positive, then the investment is considered suitable. The discount rate used could be the risk-free rate of return or the Weighted Average Cost of Capital (WACC).
Issues with Discount Rates
We can use only one discount rate at a point in time to value all future cash flows without taking into account the constant changes in interest rates and risk profiles.
The computation for the WACC, which is used as a discount rate, revolves around the usage of a company’s beta which is a measurement of the past volatility of returns for an investment. However, Beta is not a reliable indicator to know the risk in the future.