What Is a Discount Rate?
A discount rate translates money expected in the future into its equivalent value today. It captures two ideas: a dollar today can be invested and grow, and a promised future dollar might not arrive, so investors must be compensated for waiting and for bearing risk.
The mechanics are simple: Present Value = Future Cash Flow / (1 + r)^n, where r is the discount rate and n is the number of periods. The higher the rate or the further out the cash flow, the smaller its present value.
Choosing the Right Rate
The discount rate must match the risk and ownership of the cash flows being discounted. Unlevered free cash flows, which belong to all capital providers, are discounted at WACC; levered cash flows or dividends, which belong only to shareholders, are discounted at the cost of equity.
Different contexts use different benchmarks: a corporation may use its WACC plus a project premium, a private equity firm effectively applies its target IRR of 20% or more, and near-riskless government cash flows are discounted close to Treasury yields.
Example
A payment of $1,000 due in three years discounted at 10% is worth $1,000 / 1.10^3 = $751 today. At a 6% rate the same payment is worth $1,000 / 1.06^3 = $840. That $89 gap from a four-point rate change illustrates why disputes over the discount rate are really disputes over valuation itself.
Why It Matters
The discount rate is one of the two levers, alongside cash flow projections, that determine every DCF, NPV, and bond price. Because valuations are highly sensitive to it, analysts present outputs across a range of rates rather than a single point estimate.
In interviews, expect questions like "what discount rate would you use and why?" — the safe answer ties the rate to WACC for unlevered cash flows and explains how risk pushes it up or down.
