What a discount rate means
A discount rate is the required return you use to convert future cash flows into present value. Higher risk implies a higher discount rate and lower present value.
Discount rate formula (present value)
PV = sum(cash flow_t / (1 + r)^t), where r is the discount rate.
How to choose a discount rate (step-by-step)
- Start with a base rate (often WACC for firms, or MARR for projects).
- Adjust for risk: higher uncertainty -> higher rate.
- Make sure the rate matches the cash flow type (after-tax vs pre-tax).
- Test a range of rates to understand sensitivity.
WACC vs MARR vs hurdle rate
- WACC: blended required return for the firm (common DCF base).
- MARR: minimum acceptable rate of return for a project or portfolio.
- Hurdle rate: a policy rate that can include extra buffer or strategic risk.
Nominal vs real rates
- Nominal cash flows should use nominal discount rates.
- Real cash flows should use real discount rates (inflation-adjusted).
- Do not mix nominal with real; it distorts value.
Discount rate example
If your required return is 12%, $100 received in one year is worth $89.29 today ($100 / 1.12).
Common mistakes
- Using a single-point rate without sensitivity analysis.
- Using the same rate for projects with different risk profiles.
- Mixing nominal and real cash flows or tax assumptions.