What is the Correct Discount Rate?

When one is doing discounted cash flow analysis, a common question is how one determines what the discount rate should be. And if one is comparing two or more cash flow scenarios, how does one know what discount rate to use for the different cash flow series?

One easy way to determine the discount rate for DCF calculations is suggested in "The Correct Discount Rate?", a post on TedCo Software's "Financial Matters" blog: ask your Chief Financial Officer. But that only works if you have one.

What Discount Rate Should I Use?

Perhaps the best source for information about current discount rates is found on the Federal Reserve Bank of St. Louis' web site.

In the Economic Research section of the St. Louis Fed's web site you can access the current and historical Treasury Bill Rates. Rates are provided for 6 month Treasury Bills, 4 Week Treasury Bills, 3 Month Treasuries, and 1 Year Treasury Bills. For each T Bill, the web site offers a historical chart as well as the latest reported discount rates at auction.

Given the wealth of information available in the Federal Reserve Banks' historical data collection, it may still seem a bit overwhelming to choose the correct discount rate. For a quick, "will work most of the time", answer, use the latest auction discount rate for the 6 Month Treasury.

Here's why the Auction Discount Rate for the 6 Month T-Bill is Good

For most discounted cash flow analyses, the auction discount rate on the 6 Month Treasury Bills should be about the same as the rate of return you or your firm might receive on any short-term investment. And if your money is not invested in the capital project you are considering, it will probably be invested in short-term instruments. The auction discount rate on 6 month Treasuries will be close to what your money will earn if it isn't invested in the cash flow scenario you are considering.

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