The interest rate used to compute the present value of a future cash flow is called the:
Prime rate, Simple rate, Discount rate, Compound rate

Solution:

The present value of future cash flow is calculated by using the discount rate.

The discount rate can take the value of any interest rate which is existing in the environment.

The discount rate is just the name given to the rate of interest used to discount the future cash flow(s).

How the discount rate works can be demonstrated as follows:

The compounding principle is given by the following formula:

Future Value of Amount Invested (\(P_{fv}\))

= Po(1 + r/100)ⁿ --- (1)

P_o = Amount Invested in the present

R = rate of interest at which the amount is invested

\(P_{fv}\) = Future Value of the Investment Po

N = Time period for which investment is made

Now we look at the equation in another way. Suppose we are given or told that we are going to recieve \(P_{fv}\) in the future then what will be its present value.

To find the present value the formula or the equation used will not be different from equation (1).

The same equation will be reoriented as below:

Present Value (Po)

= \(P_{fv}\)/(1 + r/100)ⁿ --- (2)

Where, P_o = the present value of a future cash flow [latex]P_{fv}[/latex]

\(P_{fv}\) = The value one is going to receive in future,

r = rate of interest at which investment is made,

n = time period in the future after which an amount will be received

In equation (2) the factor containing “r” is now in the denominator and now it is called the discounting rate.

Any future cash flow is always discounted to get its present value. The discounting rate of interest can be any relevant rate of interest.

It could be prime lending rate or the saving's bank rate or any other rate which the user may deem fit.

Therefore the discounting rate can assume any value and its function is to calculate the present value of the future cash flow.

Hence, the interest rate used to compute the present value of a future cash flow is called the discounting rate.

---

The interest rate used to compute the present value of a future cash flow is called the:

Summary:

The interest rate used to compute the present value of a future cash flow is called the discounting rate.