A discount rate is a negative percentage applied to a value on an annual basis. It is often used to determine the net present value of future cash flows.

For example, the Consumer Price Index can be used as a discount rate to determine the future value of present dollars. Officially, the CPI measures the annual increases in the general cost of living. If you use its average (usually around 3% per year), and apply it to the dollar as a discount rate, you can calculate the decreasing buying power of money. (By “decreasing buying power”, I mean that if $100 buys five bags of groceries in 2009, it will buy less than five bags year after year into the future.)

• 2009: $100.00
• 2010: $100.00 – ($100.00 x 3%) = $97.00
• 2011: $97.00 – ($97.00 x 3%) = $94.09
• 2012: $94.09 – ($94.09 x 3%) = $91.27
• 2013: $91.27 – ($91.27 x 3%) = $88.53
• 2014: $88.53 – ($88.53 x 3%) = $85.87

Conversely, that tells us that what costs $85.87 today will cost $100 in 2014.

This is a useful exercise if someone offers you X dollars today versus Y dollars tomorrow. Applying a discount rate to the X dollars today over the course of the proposed timeline will tell you whether X is greater than Y.

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