The term discount rate actually has several meanings. Where interest rates and banks are concerned, the discount rate proves to be the actual interest rate that central banks charge their member depositing institutions. When these banks choose to borrow funds from the central bank or the Federal Reserve as their lender of last resort, then this is the rate that they will be required to pay them as interest.
Besides this, the discount rate can refer to the annual effective discount rate in investments. This rate turns out to be the yearly interest divided up by the capital that includes the interest. The rate provides a lower value than does the interest rate. The value following a year delay would be the nominal value in this case. The upfront value is this nominal value less a discount. This annual effective discount rate is commonly utilized for financial instruments that are like Treasury Bills.
For businesses, the discount rate is important as they are making critical decisions regarding their profits and what to do with them. When it is time to contemplate whether to purchase new equipment pieces or to instead return the profits to the share holders, this discount rate is helpful. If all else is equal, then the company will only elect to purchase the equipment if it returns a greater profit to the share holders at a future point.
The share holder discount rate would then be the dollar total that share holders expect to receive in the future so that they would rather have the company purchase the equipment now instead of return the profits to them now. Share price data is utilized to figure up the discount rate for estimating share holders’ preferences. This is called the capital asset pricing model. Businesses commonly use this discount rate when they make choices regarding buying equipment by using the net present value in the decision making process.
This discount rate proves to be the weighted average cost of capital. It shows the cash flow risk. The discount rate can also be used by companies to show two different things. It demonstrates the time value that money has, or the risk free rate. Investors generally prefer cash now than cash that they must wait for, meaning that businesses have to compensate them by making them wait for it. The discount rate also establishes a risk premium. This proves to be the additional return that investors want as payment for the possibility that they might not ever see this money if the cash flow is not there in the future.