How is the Discount Rate Used for Decision-Making?
It is the result of the discount rate on the Net Present Value calculation that affects decisions. For example, suppose that your project costs $20,000 and the annual financial benefit is $9,000 a year over 3 years. At a 5% “discount rate” your projects NPV is $4,500 (see illustration below). Suppose that instead of 5%, the discount rate is 20%; what is the NPV now? The answer is -$1,042. (Note: The Payback Period and the IRR remain unchanged even though the NPV has moved into negative territory. Why? Because simple Payback Period and IRR are not affected by the “discount rate”. This is the reason many organizations use at least two metrics in their evaluations.) So, what does this tell us? Using NPV as the decision criterion: if the discount rate is 5% the project should be considered for a “go” decision; at a 20% rate, it would be a “no-go”. The reason is that at 5%, the value of the projects financial benefits is positive; at 20%, the value is negative.
