Discount Rate Calculator

The discount rate is an interest rate used to convert future funds into a present value. It answers the simple question that is relevant for all finance: if you get money later, what's the worth of this promise to you today?

This calculator allows calculations in both directions. If you enter the future value, the present value and the period, then the implied discount rate can be calculated. Alternatively, one of the four fields can be left blank, and the tool will calculate that field. There are also built-in estimators for WACC (weighted average cost of capital) and CAPM (capital asset pricing model), which help to decide what interest rate to use.

What is a discount rate?

The discount rate represents the time value of money. A dollar today is worth more than a dollar tomorrow because you can invest that dollar and earn income from it. This interest rate reflects both the opportunity cost and risk of future cash flows. The higher the interest rate, the greater the discount on future funds, resulting in a lower present value. A lower interest rate preserves more value.

In corporate finance the discount rate is usually a company's weighted average cost of capital (WACC), i.e. the minimum return that all providers of capital to the business expect. For investors assessing external investment opportunities, the discount rate is the expected rate of return required given the amount invested and the risk involved. In both cases it represents a hurdle that future cash flows must overcome in order to justify an investment.

The formula for discount rate:

If the present value is increasing over multiple periods to become a future value, then the discount rate is equal to the future value divided by the present value, with that result raised to the power of one divided by the number of periods, and then subtracting one.

In this case, $FV$ is the future value, $PV$ is the present value and $n$ is the number of periods. If you multiply the result by 100, you will get a percentage.

An example of a calculation:

Suppose you can pay $10,000 today to acquire an asset that will be worth $15,000 in three years. What annual rate of interest does this represent?

You divide the future value by the present value, take the cube root and then subtract 1.

So the implied discount rate is about 14.47 percent. Conversely, if you discount $15,000 back three years to a present value of $10,000, then the discount rate is 14.47 percent and the discount factor, which is the present value of a future dollar, is about .667, or 10,000 divided by 15,000.

Discounting of current value and cash flows:

By rearranging the equation, one can directly calculate the current value.

This is the essence of discounted cash flow (DCF) analysis. The expected future cash flows that a project or company will generate are individually discounted to present value and then summed up. If the sum of the present values of inflows exceeds the cost of investment, then the project creates positive net present value. The most important single assumption in this calculation is the discount rate. A higher discount rate causes future cash flows, especially those far into the future, to be discounted more rapidly. This is because the value of investments with high growth prospects are highly sensitive to interest rates since these values will be realized far into the future.

Discount rate: WACC (weighted average cost of capital)

When valuing an entire company, the usual discount rate is the weighted average cost of capital. This combines the shareholders' equity cost and the after-tax cost of debt, with each component being weighted according to its share of total financing.

E is the market value of equity, D is the market value of debt, V is their sum, Ke is the cost of equity, Kd is the cost of debt and T is the tax rate. Because interest is tax deductible, the debt term is multiplied by one minus the tax rate. Therefore for most companies, taking on debt is a cheaper source of financing than equity.

Assume a company has a total value of $1,000 with equity of $800 and debt of $200, a cost of capital of 12 percent, a cost of debt of 6 percent, and a tax rate of 25 percent. If the equity is 80 percent of the funding and the debt is 20 percent, then WACC would be calculated by multiplying 0.8 times 12 percent, multiplying 0.2 times 6 percent, and multiplying that result by 0.75. The results are 9.6 percent and 0.9 percent, respectively, for a total of 10.5 percent. Open the WACC calculator above to calculate your own numbers.

Discount rate selection: Capital asset pricing model.

Many analysts use the Capital Asset Pricing Model (CAPM) to calculate the cost of equity required for WACC calculations. This model starts with a risk-free base rate and adds on a risk premium that is based on how correlated an investment will be with the market, in order to determine the required return.

Rf is the risk-free rate of return, typically the long-term government bond yield. Beta measures sensitivity to the overall market and Rm is the expected market return. The value in brackets, i.e. the difference between the market return and the risk-free rate, is the equity risk premium. If the risk-free rate is 4 percent, beta is 1 and the expected market return is 10 percent, then the cost of equity is 10 percent, with 4 percent being the product of 1 and 6 added together. The higher the beta, the higher the required return, and if beta is below 1, the required return will be lower.

Another method of calculating the cost of equity is the Gordon Growth Model which is based on dividends. The cost of equity is equal to the expected dividend for next year divided by the current stock price plus the long-term growth rate of the dividend. This works well for companies with stable dividend payouts, while CAPM is a more versatile tool.

Discount rate, cost of capital, minimum return

These three terms overlap but are not identical. The cost of capital is the cost that a company incurs to raise its funds, and it becomes a discount rate when valuing an entire company. The hurdle rate is the minimum return on investment that a company requires in order to approve a project. It's usually set at several percentage points above the WACC to provide a buffer for default risk. A company with a WACC of 10 percent would use this as its base discount rate, while it might require a return of 12 to 15 percent before approving riskier new investments.

Typical discount rates by industry

There is not one correct interest rate. It depends on the size of the cash flow risk. The following ranges are a rough guideline for average WACC (weighted average cost of capital) for companies in today's market environment. For smaller companies, it will be higher by several percentage points due to a size premium.

How to Interpret Results:

A low discount rate (below about 6 percent) indicates stable and predictable cash flows. This is the type of cash flow found in utility companies or established monopolies. In competitive markets, the typical discount rate for established businesses is between 9 and 12 percent. A high discount rate above 15 percent indicates start-ups, distressed companies, or industries with high volatility. Investors demand a higher return due to the uncertainty in these areas. Always compare the expected return of a project to the discount rate. If the return exceeds the discount rate, the project creates value; if it falls below, it destroys value.

Limitations:

The quality of the discount rate depends on the inputs used. Even a small change in the interest rate can lead to significant changes in the valuation. This is especially true for cash flows that are far in the future, where even seemingly accurate answers may be based on uncertain assumptions. Because WACC uses market value and a single blended interest rate, it may not be appropriate for projects with risk profiles that differ from those of the company. Additionally, the formula used here for time value of money assumes that a given present value will grow to a given future value, and no additional funds are added or withdrawn during this period. For irregular cash flow series, a full discounted cash flow analysis (DCF) or internal rate of return should be used instead.