Introduction
As per the context, the term discount rate has many usage and definitions. Firstly, discount rate points to the rate of interest that is going to be paid by the banks and other financial institutions on the credits that they avail from the central bank of a country through discount window loan procedure.
Secondly, discount rate points to the rate of discount which is made use of in a discounted cash flow analysis (DCF) in determining the current value of the predicted cash flows in future.
DCF Analysis
The term discount rate is extensively used in the discounted cash flow analysis, which is often referred to as DCF analysis. DCF is one of the most commonly used methods to evaluate and estimate the worth of an investment as per its anticipated cash flows in future.
On the basis of the time value of money concept, the DCF analysis will help in assessing the practicality of a project or investment by estimating the current value of the anticipated cash flows in future through a discount rate.
Breaking Down Discount Rate
In simple words, if a particular project currently needs some investment and sometime in future as well, and estimations are accessible regarding the possible returns it is going to generate in future, then it is possible to determine the present value of cash flows using the discount rate.
If the present value is in positive terrain (after deducting all expenses and taxes), then the project is said to be a viable one. If not, then it is said to be financially not feasible as it will cause financial hindrance. The discount rate, in DCF context, refers to the rate of interest, which is utilised to calculate the current value.
