Q:

How do you calculate a discount rate?

A:

Use either the yield on a 10-year US Treasury bond plus 5 percent or the weighted average cost of capital to calculate the discount rate. The discount rate is defined for investors as the rate at which dollars in the future are brought back to their present value.

Simply put, the discount rate is equal to the interest rate it will take to make a sum of money today equal to a value in the future, just applied in reverse. For example, if a person wants to have $100 two years from now and the current rate is 5 percent, then he should invest $90.70 today in order to reach that goal. Therefore, the discount rate of 5 percent is applied to the $100 amount in order to bring it back to the current value of $90.70. All of those calculations simply mean that $100 is worth $90.70 today.

The discount rate varies depending on who is doing the calculations. Different discount rates give different present-day values. The larger the rate, the lower the value. Some investors prefer to use a larger discount rate, especially for risky securities like small cap stocks. Future cash flows with these types of investments tend to be more volatile, and a larger discount rate gives investors a bit of a cushion.

Sources:

  1. boundless.com

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