Discount rate is the rate of return (interest rate) used in discounted cash-flow calculations. Most often, it is cost of capital, but other rates are also possible.
Discount rate can be:
The higher is the discount rate, the lower NPV will be achieved and it is less probable that the project will be accepted.
The right choice of discount rate depends on the purpose. To decide whether the investment project will add value, WACC will be sufficient. Rate of return on alternative investment opportunity may be appropriate when deciding between mutually exclusive projects. (30)
With respect of the inflation covered, discount rate can be either:
Nominal discount rate includes inflation and can be derived by Fisher equation as:
(1 + real discount rate) * (1 + inflation rate) – 1
There are two possibilities how to incorporate inflation to NPV calculation:
With respect of the income tax rate covered, discount rate can be either:
If relevant cash-flows in the calculation include the tax effects, after-tax discount rate shall be used.
30. Net present value (online). Citation date: 19.1.2016. Available from www: https://en.wikipedia.org/wiki/Net_present_value
31. Obaidullah Jan, ACA, CFA. NPV and inflation (online). Citation date: 19.1.2016. Available from www: http://accountingexplained.com/managerial/capital-budgeting/npv-and-inflation