Discount rate

What it means

The discount rate is the percentage used to convert future money into present value. It rests on the fact that a euro today is worth more than a euro in a year: it can be invested, earn interest, and carries less risk of never arriving.

It is used in every time-value calculation: in the net present value of an investment, in a DCF valuation and when comparing offers with different payment schedules. The higher the rate, the less a cash flow that arrives later is worth today.

For a company it is most often set as the weighted average cost of capital, WACC: what loan interest costs after tax and what return the owners expect. A premium for the risk of the particular project or of a small company is added on top.

How it works in practice

In a client’s investment decision, for example on buying a machine or a solar installation, the discount rate answers the question of whether it pays: a project with a positive NPV at a reasonable rate earns more than the money costs. We also compare it with the IRR, which shows the rate at which the project breaks even.

In the books, discounting appears with long-term items, such as long-term provisions or when determining fair value, although Slovak rules for smaller companies require it only exceptionally. It is standard in IFRS accounts.

For start-ups and early-stage companies high rates are used, often tens of percent, reflecting the risk of failure. Venture capital investors use them to express the return they need for one success to pay for several failures.

What to watch out for

A valuation is highly sensitive to the rate. For long-term projects one or two percentage points can change the value by tens of percent, so we always justify the rate and test it with a sensitivity analysis.

A mistake is using the same rate for every project regardless of risk, or mixing nominal cash flows with a real rate that excludes inflation. A quick payback period calculation without discounting also undervalues long projects and overvalues short ones.