Definition: Discount rate; also called the hurdle rate, cost of capital, or required rate of return; is the expected rate of return for an investment. In other words, this is the interest percentage that a company or investor anticipates receiving over the life of an investment.
What Does Discount Rate Mean?
It can also be considered the interest rate used to calculate the present value of future cash flows.
Thus, it’s a required component of any present value or future value calculation. Investors, bankers, and company management use this rate to judge whether an investment is worth considering or should be discarded.
Example
For instance, an investor might have $10,000 to invest and must receive at least a 7 percent return over the next 5 years in order to meet his goal. This 7 percent rate would be considered his discount rate. It’s the amount that the investor requires in order to make the investment.
The discount rate is most often used in computing present and future values of annuities. For example, an investor can use this rate to compute what his investment will be worth in the future. If he puts in $10,000 today, it will be worth about $26,000 in 10 years with a 10 percent interest rate.
Conversely, an investor can use this rate to calculate the amount of money he will need to invest today in order to meet a future investment goal. If an investor wants to have $30,000 in five years and assumes he can get an interest rate of 5 percent, he will have to invest about $23,500 today.
These examples assume that discount rates only apply to investors calculating annuities and other investments. The fact is that companies use this rate to measure the return on capital, inventory, and anything else they invest money in. For example, a manufacturer that invests in new equipment might require a rate of at least 9 percent in order to break even on the purchase. If the 9 percent minimum isn’t met, they might change their production processes accordingly.
