![]() Other central banks also have similar discount rates. The discount rate acts as a benchmark for interest rates issued. In US central banking, the term 'discount rate' means the interest rate that member banks pay the Federal Reserve when the banks use securities as collateral. Historically it was common to use the blended rate of investment return expected on the actual assets in the scheme, but typically now a market rate is used, such as the government bond or AA corporate bond yield for a fixed income security with a similar duration to that of the underlying liabilities. In the field of pensions, discount rate means the rate used to discount future liabilities of a Defined benefit pension scheme in order to calculate the present value of the liabilities, often for the purpose of comparing them with the market value of the scheme’s assets. The discount rate of 20% and the yield of 25% both summarise the same deal, using different conventional bases. £8m is invested now, and £10m is repaid at the end of one period. Notice that the discount rate and the yield calculated above both relate to exactly the same deal. The starting amount for an investment is £8m. ![]() This is different from a yield or interest rate, which is conventionally quoted based on a percentage of the starting amount. In the US the market, discount rate is sometimes known as the discount yield. The gain for the single period from the start to the final maturity is £2m. The maturity amount for an investment is £10m. Second, the discount rate is used as an interest rate charged to the financial institutions for loans that they get from the Federal Reserve Bank via the window discount loan process. The market discount rate is quoted based on a percentage of the maturity amount. First, the discount rate is the interest rate used in the discounted cash flow (DCF) analysis to get the present value of cash flows in the company. In short-term financial markets, 'discount rate' means the quoted market rate for traded instruments quoted at a discount. The choice of discount rate should reflect the risks of the investment or project. ![]() In this context, discount rate is the generic name for the rate of interest at which the future cash flows of a proposed investment are discounted, in order to obtain the net present value of the cash flows. ![]() LOS 21 (h) Evaluate the appropriateness of using a particular rate of return as a discount rate, given a description of the cash flow to be discounted and other relevant facts.'Discount rate' is often used as a synonym for the cost of capital. The weighted average cost of capital is used to discount cash flows to the firm to estimate the value of the entire firm. The rate of return on debt is used to estimate the amount of debt repayments that the firm makes on its debt.Ĭ is incorrect. The rate of return on equity is the discount rate that would be used to discount cash flows to equity to estimate the value of equity of the firm.Ī is incorrect. Which discount rate would most appropriately discount cash flows to equity to estimate the value of equity for a firm? When a cash flow is available to meet the claims of all of a company’s capital providers, the firm’s weighted average cost of capital is the appropriate discount rate. When discounting cash flows analysts should use the discount rate that is consistent with the type of cash flow being discounted.Ī cash flow to equity should be discounted at the required rate of return on equity. ![]()
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