What is Discount Rate in NPV Calculations?

The discount rate in Net Present Value (NPV) calculations is the rate used to convert future cash flows into present value. It reflects the time value of money and the risk or opportunity cost of investing capital elsewhere. A higher discount rate reduces the present value of future cash flows, potentially making an investment less attractive.

Definition Table

Term	Definition
Discount Rate	The interest rate used to convert future cash flows into present value during an NPV analysis. It accounts for the risk of the investment and the opportunity cost of capital.
Time Value of Money	The concept that money available now is worth more than the same amount in the future due to its earning potential.
Risk Premium	An additional return expected by investors for taking on higher risk, often factored into the discount rate.

Example: NPV with Different Discount Rates

Scenario:
An investor expects to receive $10,000 per year for 3 years from a real estate investment.

NPV Formula

Where:

t = year (1, 2, 3)
r = discount rate
Cash Flow = $10,000/year

Calculation

Discount Rate	NPV Calculation	Resulting NPV
5%	10,000 ÷ 1.05 + 10,000 ÷ 1.05² + 10,000 ÷ 1.05³ = 9,524 + 9,070 + 8,638	$27,232
10%	10,000 ÷ 1.10 + 10,000 ÷ 1.10² + 10,000 ÷ 1.10³ = 9,091 + 8,264 + 7,513	$24,868
15%	10,000 ÷ 1.15 + 10,000 ÷ 1.15² + 10,000 ÷ 1.15³ = 8,696 + 7,561 + 6,575	$22,832

Interpretation

As the discount rate increases, the NPV decreases. That’s because future cash is considered less valuable when your expected return (or risk) is higher.