Writing in ThoughtCo. (reference below, link on right), Mike Moffat defines discount rate as the interest rate at which an agent discounts future events in preferences in a multi-period model.
Time value of money and uncertainty risk
“In order to determine the current value of future cash flow, which is essentially the point of applying the discount rate to business endeavors, one must first evaluate the time value of money and the uncertainty risk wherein a lower discount rate would imply lower uncertainty the higher the present value of future cash flow.
“The time value of money is different in the future because inflation causes cash flow tomorrow to not be worth as much as cash flow is today, from the perspective of today; essentially this means that your dollar today will not be able to buy as much in the future as it could today.
“The uncertainty risk factor, on the other hand, exists because all prediction models have a level of uncertainty to their predictions. Even the best financial analysts cannot fully predict unforeseen events in a company’s future like decreases in cash flow from a market collapse.
As a result of this uncertainty as it relates to the certainty of the value of cash presently, we must discount future cash flows in order to properly account for the risk a business makes in waiting to receive that cash flow.
Another common usage of the term discount rate
Moffat notes that there is a second common usage of the term:
“In the United States, the U.S. Federal Reserve controls the discount rate, which is the interest rate for the Federal Reserve charges commercial banks on loans they receive. The Federal Reserve’s discount rate is broken into three discount window programs: primary credit, secondary credit, and season credit, each with its own interest rate. … According to the Federal Reserve’s website, “The discount rate charged for primary credit (the primary credit rate) is set above the usual level of short-term market interest rates… The discount rate on secondary credit is above the rate on primary credit… The discount rate for seasonal credit is an average of selected market rates.” In this, the primary credit rate is the Federal Reserve’s most common discount window program, and the discount rates for the three lending programs are the same across all Reserve Banks except on days around a change in the rate.”
Atlas topic, subject, and course
Mike Moffat (2017), What is the Discount Rate? ThoughtCo., at https://www.thoughtco.com/discount-rate-definition-1146078, accessed 29 January 2018.
Page created by: Ian Clark, last modified 29 January 2018.
Image: Alex Edmans (2015), Dangers of Using a Company-Wide Discount Rate, at http://alexedmans.com/dangers-of-using-a-company-wide-discount-rate/, accessed 29 January 2018.