What is the Discount Rate?
The discount rate refers to the Federal Reserve's interest rate for short-term loans to banks, or the rate used in a discounted cash flow analysis to determine net present value.
The discount rate has two distinct financial meanings. The first refers to the interest rate charged when banks take out short-term loans from the Federal Reserve. Raising or lowering the discount rate allows the Federal Reserve to encourage banks to be more conservative or aggressive in their lending practices. The second use of discount rate, as used in the term the “discounted rate of return,” is used to determine what a cash flow is worth in the present, given its anticipated future value. Determining the cash flow’s value in this manner is called a discounted cash flow analysis. The discount rate is used to determine a cash flow’s net present value, or the sum of all positive and negative future cash flows.
If the Bank of America hypothetically made an unusually high number of loans in a day, it might get a loan to make sure it met its reserve requirements. The bank could get that loan from the Federal Reserve. It would need to pay that loan back in about 24 hours, and it would pay interest. The interest rate charged would be the current discount rate.
Alternatively, let's say you were considering buying a business that had a good track record of consistent revenue. You could figure out what to offer the current owners using the discount rate to estimate what the company’s net present value is.
The discount rate is like a plumber’s wrench or a time-traveling calculator...
Just as a plumber can use the wrench to increase or decrease the flow of water through a pipe, the Federal Reserve can use the discount rate to increase or decrease the flow of money through the economy. And although you may not be able to predict what happens in the future with perfect accuracy, the discounted rate of return is like a time-traveling calculator that can help you estimate what an assets’ future value is worth today.
The most common use of the term discount rate is to refer to the interest rate the Federal Reserve charges on short-term loans it makes to banks. In most situations, the banks only need the loans for a day or less, and they pay many of these loans back in less than 24 hours.
The program as a whole is known as the “discount window,” which consists of three separate tiers.
The top tier is the primary credit rate. Banks that have a good financial record qualify for these loans, which carry the lowest interest rates.
The second tier is the secondary credit rate. Banks with ongoing financial issues qualify for this tier. Because the loans are riskier, the Federal Reserve generally charges half a percentage point more interest on these loans than they do on primary credit loans.
Finally, there is a seasonal discount rate. The Federal Reserve generally provides these loans to small banks and credit unions that serve a community. As the name implies, these loans compensate for seasonal lending activity. Farmers and students are groups likely to take out a lot of loans at similar times in the year, which can dramatically reduce a bank’s reserve cash. Consequently, banks must prove that a seasonal pattern is responsible for swings in liquidity to receive a loan. However, loans made at the seasonal discount rate can offer up to nine months for repayment. Unlike the other two discount rates, seasonal discount rates vary with market conditions.
Banks make money in part by loaning out their deposits through mortgages, personal loans, and other types of loans. However, banks are required to maintain a minimum amount of money on hand at the end of the day. The money kept on hand ensures that the people who deposited money at the bank will be able to withdraw it when they need it.
The amount of money banks must possess at the end of a business day in relation to their assets is known as the reserve ratio. Banks with $16.9M or less in assets don’t have to hold any money in reserve. Banks with more than $16.9M and up to $127.5M must hold 3%of their total liabilities in reserve. Those with more than $127.5M must keep at least 10% in reserve.
If banks have too little money on hand to cover their reserve ratio, then they can be subject to fines. If the bank is unable to borrow money from another bank or raise money by selling assets such as government bonds, then it can make use of the discount window to cover the reserve requirement.
However, the discount rate isn’t just used to keep banks in good regulatory standing. It’s also a powerful tool used to protect the economy as a whole. By changing the discount rate, the Federal Reserve can encourage banks to be more aggressive or conservative in their lending.
Raising the rate can help reduce inflation when the economy is growing, and lowering it can help create growth when times are tough.
The phrase “discount rate” can also refer to the rate used in discounted cash flow analysis –- A tool used to determine the value of a business or investment based on its anticipated future revenue.
If you want to purchase a company, you’ll need to determine what it is worth before you make an offer. And if the business has a history of regular cash flow, it may be a good candidate for a valuation calculation based on future expected cash inflows and outflows. To complete this calculation, you use a discount rate to figure out what those expected future cash flows should be worth today.
If you decide to determine the company’s or investment’s value using future cash flows, you run into a few problems. Due to inflation, the money you could get in the future is almost certainly worth less than it would be if it were in your pocket now. Likewise, there’s always a risk that money you’re owed may not get paid to you, or that the market could change or crash and damage a business.
Consequently, the money you could get in the future is worth less than the money you have now, a concept known as the “time value of money.” If you’re trying to determine what a business or investment is worth now, with the time value of money factored in, you’re doing a “discounted cash flow analysis.” The value that analysis produces, or the value of the company or investment in the present, is known as the “net present value.”
The discount rate is a tool used to test the company in different ways. Differing types of discount rates can generate different results for net present value.
Types of discount rates include:
One way to calculate the discount rate is using the Weighted Average Cost of Capital (WACC).
The formula for WACC is:
As you can see, you have to calculate the cost of debt and equity before you can perform a WACC analysis.
If you’re calculating the discount rate using a calculator, you’ll want a graphing calculator, or a model capable of grouping calculations together in an appropriate order of operations. If you only have a simple calculator, you can make the process easier by doing the calculation in two stages.
First, calculate the equity-related value (the part before the plus sign), then the debt-related value (the part after the plus sign). Then add the two numbers together.
You can also make these calculations in Excel by assigning each listed value to a cell. Then write a formula that uses the cell values to perform the WACC analysis.
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