Fed’s Discount Rate: Fed’s Tool and DCF Analysis Explained

 

Understanding the Fed’s Discount Rate

The term “discount rate” has dual significance in financial analysis. Firstly, it is the interest rate set by the Federal Reserve for short-term loans to commercial banks through the discount window, a critical tool for managing liquidity in the banking sector. Secondly, it is the interest rate used in discounted cash flow (DCF) analysis to evaluate the present value of projected future cash flows from investments, guiding investors in their decision-making process.

 

How the Federal Reserve Implements the Discount Rate

U.S. commercial banks can borrow short-term funds by either using the market-driven interbank rate, which requires no collateral, or by borrowing from the Federal Reserve Bank.

Federal Reserve loans, processed through its 12 regional branches, help financial institutions cover cash shortfalls, address liquidity issues, or, in critical situations, prevent bank failures. This Fed-offered lending facility is known as the discount window.

These loans are very short-term, often 24 hours or less, and carry an interest rate set by the Federal Reserve Board of Governors.

Exploring the Three Tiers of Fed Discount Window Loans

The Fed’s discount window program runs three tiers of loans, each using a separate but related rate. It also allows for emergency credit approvals for banks in distress.

The Fed determines the discount rates for the first two tiers independently. The rate for the third tier is based on the prevailing rates in the market.

• First Tier: Called the primary credit program, this tier provides capital to financially sound banks with good credit records. This primary credit discount rate is usually set above existing market interest rates, which may be available from other banks or other sources of similar short-term debt.
• Second Tier: Called the secondary credit program, it offers similar loans to institutions that do not qualify for the primary rate. It is usually set 50 basis points higher than the primary rate (one percentage point = 100 basis points). Institutions in this tier are smaller and may not be as financially healthy as the ones that use the primary tier.
• Third Tier: Called the seasonal credit program, this one serves smaller financial institutions, which experience higher seasonal variations in their cash flows. Many are regional banks that serve the needs of the agriculture and tourism sectors. Their businesses are considered relatively risky, so the interest rates they pay are higher.
• Emergency Credit: Banks applying for emergency credit must demonstrate proof that they cannot find a loan from another bank and require a vote with the support of at least five members of the Board of Governors of the Federal Reserve.

Practical Applications of the Fed’s Discount Rate

Banks use the Fed’s discount window mainly when market lenders are unavailable. The Fed-offered discount rates are available at relatively high-interest rates compared to the interbank borrowing rates to discourage using the discount window too often.

The discount window is mainly for emergencies, and borrowing from it can signal financial trouble to others.

 

Historical Example: Fed Discount Rate in Action

The use of the Fed’s discount window soared in late 2007 and 2008 as financial conditions deteriorated sharply and the central bank took steps to inject liquidity into the financial system.

In August 2007, the Board of Governors cut the primary discount rate from 6.25% to 5.75%, reducing the premium over the Fed funds rate from 1% to 0.5%. In October 2008, the month after Lehman Brothers’ collapse, discount window borrowing peaked at $403.5 billion against the monthly average of $0.7 billion from 1959 to 2006.

Due to the financial crisis, the board extended loan terms from overnight to 30 days, and later to 90 days in March 2008. Once the economy recovered, those temporary measures were revoked, and the discount rate was reverted to overnight lending only.

The Fed maintains its own discount rate under the discount window program in the U.S. Most central banks across the globe use similar measures, although they vary by area. For instance, the European Central Bank (ECB) offers standing facilities that serve the same purpose. Financial organizations can obtain overnight liquidity from the central bank against the presentation of sufficient eligible assets as collateral.

 

Applying the Discount Rate in Cash Flow Analysis

The same term, discount rate, is used in discounted cash flow analysis. DCF is used to estimate the value of an investment based on its expected future cash flows. Based on the concept of the time value of money, DCF analysis helps assess the viability of a project or investment by calculating the present value of expected future cash flows using a discount rate.

Such an analysis begins with an estimate of the investment that a proposed project will require. Then, the future returns it is expected to generate are considered. Using the discount rate, it is possible to calculate the current value of any future cash flows. The project is considered viable if the net present value (PV) is positive. If it is negative, the project isn’t worth the investment.

In DCF analysis, the discount rate is the interest rate used to find the present value. For instance, investing $100 today at a 10% interest rate grows to $110. In other words, $110, which is the future value (FV), when discounted by the rate of 10%, is worth $100 (present value) as of today.

If one knows (or can reasonably predict) all such future cash flows (like the future value of $110), then, using a particular discount rate, the present value of such an investment can be obtained.

 

What Is the Right Discount Rate to Use?

What is the appropriate discount rate to use for an investment or a business project? While investing in standard assets, like treasury bonds, the risk-free rate of return—generally considered the interest rate on the three-month Treasury bill—is often used as the discount rate.

On the other hand, if a business is assessing the viability of a potential project, the weighted average cost of capital (WACC) may be used as a discount rate. This is the average cost the company pays for capital from borrowing or selling equity.

In either case, the net present value of all cash flows should be positive if the investment or project is to get the green light.

 

Types of Discounted Cash Flow

There are different types of discount rates that apply to various investments of a business. What type is required depends on the needs and demands of investors and the company itself. Here are the most common:

• Cost of Debt: Companies must take on debt to finance their operations and keep the business running. The interest rate they pay on this debt is known as the cost of debt.
• Cost of Equity: The cost of equity is the rate corporations use to pay their shareholders. Investors expect a specific rate of return in exchange for taking on the risk of investing in a company.
• Hurdle Rate: The minimum rate of return on a certain investment or undertaking is known as the hurdle rate. This allows them to make important decisions on whether the venture is a good fit.
• Risk-Free Rate: The risk-free rate is the interest rate that comes with an investment or business venture with no risk.
• Weighted Average Cost of Capital: This is the rate of return that investors expect for their capital. Investors can include equity shareholders and bondholders.

 

Calculating the Discount Rate

To calculate the discount rate, use the following formula:

DR = ( FV ÷ PV ) ^1/n – 1

Where:

• FV = Future value of cash flow
• PV = Present value
• (n) = Number of years until the FV

Here’s an example to show how the discount rate works. Let’s say you want to determine the discount rate on a certain investment using the following variables:

Future Value	$5,000
Present Value	$3,500
Number of Years	10

Now, let’s use the formula above to determine the discount rate. For the fractional exponent, you can convert it to a decimal ( 1 ÷ 10 ):

DR = ( FV ÷ PV ) ^1/n – 1
DR = ( $5,000 ÷ $3,500 ) ^1/10 – 1
DR = $1.42857 ^0.1 – 1
DR = 1.03631 – 1
DR = 0.03631

So, in this case, the discount rate is 3.631%.

 

What Effect Does a Higher Discount Rate Have on the Time Value of Money?

The discount rate reduces future cash flows, so the higher the discount rate, the lower the present value of the future cash flows. A lower discount rate leads to a higher present value. As this implies, when the discount rate is higher, money in the future will be worth less than it is today—meaning it will have less purchasing power.

 

How Is Discounted Cash Flow Calculated?

There are three steps to calculating the DCF of an investment:

• Forecast the expected cash flows from the investment.
• Select an appropriate discount rate.
• Discount the forecasted cash flows back to the present using a financial calculator, a spreadsheet, or a manual calculation.

 

How Do You Choose the Appropriate Discount Rate?

The discount rate used depends on the type of analysis undertaken. When considering an investment, the investor should use the opportunity cost of putting their money to work elsewhere as an appropriate discount rate. That is the rate of return that the investor could earn in the marketplace on an investment of comparable size and risk.

A business can select the best discount rate, like an opportunity cost-based rate, its weighted average cost of capital, or returns from a similar project. In some cases, using the risk-free rate may be most appropriate.

 

The Bottom Line

The discount rate is the lending rate at the Federal Reserve’s discount window, where banks can get a loan if they can’t secure funding from another bank on the market. A discount rate is also calculated to make business or investing decisions using the discounted cash flow model.