Discount rate - definition and how to calculate it

Read our guide to what the discount rate is, how to calculate it, and an example.

Learn about future cash flows

When looking ahead to future cash inflows and cash outflows, calculating the discount rate can help look ahead to the future and thereby protect your liquidity. Being aware of the discount rate will help your cash flow analysis and inform better decisions before you invest liquid capital or embark on a new project.

Future cash flow diagram
There are lots of softwares out there that can help with cash flow forecasting. Including Futrli Predict.

This is why we've compiled this guide to the discount rate and how to calculate it.

Discount rate - explained

The discount rate describes the interest rates applied in a discounted cash flow analysis. While evaluating the present value of cash flow is a well-known process with different options, calculating the discount rate allows us to make projections regarding future cash flows.

How to calculate the discount rate

When deciding on an investment, it is key to understand whether the capital costs of the investment, be it equipment or a new team member, will pay off in monetary value. While there is no defined way of identifying the discount rate, we can recommend starting with the weighted average cost of capital. Here, you calculate the rate based on the time value of money and the uncertainty risk. Time value of money is usually informed by tracking interest rates and inflation, while uncertainty risk is informed by market volatility and competitor analysis. The higher the discount rate, the higher the uncertainty levels on the market.

A key factor in this calculation is what is called the project or investment's free cash flow. This describes the cash left after your upfront investment is made. This can then be used to identify the net present value. For risky projects, we advise adding a risk premium to ensure that future cash flow isn’t compromised by a lack of foresight.

Cost of capital

The cost of capital describes the debt you are taking on in order to finance an investment or ease cash flow. If there is interest to be paid back on the capital required, the net interest is factored into the cost of capital. If stock issues were used to finance the investment, you would use the cost of equity as the cost of capital.

Euro notes
The cost of capital describes the debt you are taking on in order to finance an investment or ease cash flow.

Example

Company A has made a name for itself in its sector - being an established player with a consistent market share and positive reputation, it is a profitable endeavor. However, there is not a lot of potential for growth. This means that the business owner might want to invest in new ventures, such as the development of a new product to attract customers and a new target audience. When making a decision, the company could use the discount rate to calculate whether the prospective investment will pay off. The business owner could calculate the viability and future profitability of their potential investment.

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