Discount rate

Discounting criteria

The preferred method of applying discount rates to cost/benefit analysis and to investment appraisal is by the calculation of the "net present value" of future flows of cost and benefits using the formula set out on the tutorials subpage. Allowances for risks are made, either by adjustments to the risk-free discount rate, or by using specific probability estimates to calculate a "net present expected value"

Discount rates in cost/benefit analysis

The social opportunity cost rate

The social opportunity rate is based upon the discount rates used for investment appraisal by private sector companies.

The social time preference rate

The social time preference concept of discounting, arises from the behavioural observation that people prefer immediate satisfaction to deferred satisfaction. Thus the term “discount rate” refers to the compensation in terms of increased utility that a person requires as inducement to defer consumption (usually as a percentage per annum). The discount rate that a person experiences assuming no expectation of changing circumstances, is sometimes termed his “pure time preference rate” - to distinguish it from the inducement that he would require if he expected his consumption to increase. In that case, he would take account of the fact that, as his total consumption increased, he would experience a reduction in the marginal utility of any further increase . The proportionate further compensation that a person requires to take account of its diminishing marginal utility is referred to as that person’s “elasticity of the marginal utility of consumption”. (The derivation of that concept is attributed to a 1928 paper by the economist Frank Ramsey . There is a note on the “Ramsey equation”, and the estimation of the associated elasticity measure, on the tutorials subpage.). A community’s discount rate, taking account of rising consumption, is termed its “social time preference rate”. The social discount rate of a community togeher with its liquidity prefernce are major determinants of its market interest rate.

Discount rates in financial theory

In financial theory, the uses of the term “discount rate” include its application to a variety of interest rates, including the rate charged for loans made to a country’s banks by its central bank , and the rates of return that are used as investment criteria by companies and by government agencies .