Discount Rates: Discounting dilemmas (2024)

FAQs

What are the problems with the discount rate? ›

When discount rates are high, banks may lend less to consumers. As a monetary tool, the Federal Reserve may raise discount rates to encourage people to borrow less and save more. In the short term, high discount rates make loans more expensive, which takes money out of the economy.

If the discount rate is negative it means that the cashflow has negative risk and you'll have to pay out of your pocket to earn that cash flow. Although theoretically possible, it makes no economic sense. Why is the present value of any future amount greater when the discount rate is lower?

While there is considerable debate regarding the appropriate discount rate to apply to any cost-benefit analysis conducted across generations, most climate models choose one rate (2-7 percent is a common range) and hold it constant over the time horizon of the model.

Obviously, if you sell a product or service at full price, your margin will be higher than if you sell at a discount. Conversely, the profit margin you lose through discounting has to be made up for in future opportunities, causing you to exert more sales effort and close more deals at a higher price to compensate.

Pro: Great to boost sales and gain new customers. Con: Excessive discounting can lead to financial loss and harm brand reputation. As well, you could be missing the opportunity to target specific customer segments. Ex: Walgreens offering 50% off on CeraVe, Clean&Clear, and Aveeno.

A lower discount rate leads to a higher present value. As this implies, when the discount rate is higher, money in the future will be worth less than it is today—meaning it will have less purchasing power.

If the Fed lowers the discount rate, it encourages banks to lend more money (since they can increase their reserves at a lower cost). The result is more loans for businesses and consumers, meaning an increase in the money supply, which spurs economic activity but also leads to greater inflation.

A negative discount rate means that present value of a future liability is higher today than at the future date when that liability will have to be paid.

What is the current discount rate today? ›

US Discount Rate is at 5.50%, compared to 5.50% the previous market day and 5.25% last year. This is higher than the long term average of 2.15%.

An equity discount rate range of 12% to 20%, give or take, is likely to be considered reasonable in a business valuation. This is about in line with the long-term anticipated returns quoted to private equity investors, which makes sense, because a business valuation is an equity interest in a privately held company.

A low discount rate, conversely, places a greater emphasis on the benefits of avoided emissions to future generations, and therefore results in a higher social cost of carbon. These social costs are then used in cost-benefit analyses of proposed projects or policies.

The conventional instantaneous Ramsey discounting rule says that the optimal discount rate equals the pure rate of time preference plus the product of the individual degree of relative risk aversion multiplied by the growth rate.

A high discount rate means that future effects are considered much less significant than present effects, whereas a low discount rate means that they are closer to equally significant. The effects of different discount rates on estimates of the SCC can be seen in the table below.

Limitations to the Discount Yield Measure

For simplification of calculation, the discount yield is annualized, taking into account a 360-day year rather than the actual 365-day year. It creates a slight problem because the interest on bonds and Treasury bills is paid on a 365-day basis.

This can lead to erroneous decisions to repurchase shares. This can lead to mistaken investment decisions. This can lead to mistaken calculations of earnings before interest and taxes (EBIT).

The formula to calculate the discount rate is: Discount % = (Discount/List Price) × 100. For example, if the list price of an item is $80, and a $10 discount is offered on the item, then the discount percent will be (10/80) × 100, which is equal to 12.5%.

Why Does the Federal Reserve Change the Discount Rate? The Federal Reserve increases or decreases the discount rate (and the federal funds rate target) in order to curtail or stimulate the overall level of economic activity in the country.