Finance - Discount Rate - Example

A critical element in determining net present value is the “discount rate” used in an individual’s calculations. This is the rate at which future cash flows are adjusted to the present day. Setting an accurate discount rate is both an art and a science, as it must take into account such things as inflation, investment risk and the “cost of capital,” which is how much it costs an individual to “use” money -- either by borrowing it from others (and paying interest) or by the individuals spending the money (and not earning an investment return on it). In general, future cash flows get discounted to the present day using this formula: C/(1+r)^n. The “C” is the future cash flow, either positive (a benefit) or negative (a cost). The “r” is the discount rate per period (usually a year). The “n” is the number of periods between now and the time the cash flow occurs.