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- The interest rate the Federal Reserve charges banks for short-term borrowing from its discount window. The federal discount rate and primary credit rate are other names for this rate. It is one of the tools of monetary policy that the Fed employs to affect market interest rates and liquidity. This rate is set by the Fed higher than the federal funds rate, which is the market-based price that banks charge one another for overnight loans. For banks that experience short-term liquidity issues and are unable to borrow from other sources, the Fed's discount window acts as a lender of last resort. The discount rate used by the Fed to indicate its stance on monetary policy has an impact on other interest rates in the economy.
- The interest rate that is applied in discounted cash flow (DCF) analysis to discount future cash flows to their present value. This rate is also known as the hurdle rate or necessary rate of return. It stands for the lowest return that an investor or business anticipates from a project including investments. It illustrates how risky and expensive investment in a project is in comparison to other options. Future cash flows have a lower present value due to the higher risk or opportunity cost implied by a higher discount rate. A higher present value of future cash flows results from a lower discount rate since it suggests a reduced risk or opportunity cost.
Several techniques can be used to compute the discount rate depending on the sort of investment project being undertaken and the data that is at hand. Some common methods are:
- Weighted average cost of capital (WACC): Using a combination of debt and equity financing, this method determines the typical cost of financing an investment project. Every source of capital is considered, along with the ratio, price, and tax ramifications. It is frequently used to value businesses or initiatives with risk profiles comparable to those of already established ones.
- Capital asset pricing model (CAPM): Using the risk-free rate, market risk premium, and beta coefficient, this approach determines the necessary return on equity. It is predicated on the notions of reasonable, diversified investors and effective markets. It is frequently applied to projects or individual assets with differing risk profiles from current ones.
- Arbitrage pricing theory (APT): Using a variety of variables that have an impact on an asset's projected return, this approach determines the needed return on an asset. It is predicated on the idea that financial markets do not offer arbitrage possibilities, therefore assets with comparable risks ought to yield comparable returns. It is frequently applied to appraising projects or complicated assets with several risk factors.
