Types of Interest Rates

Interest rates are how we measure the time value of money. While making an investment, an investor will need to know the interest rate that the investment will earn. The interest rates can be interpreted in many ways.

Required Rate of Return

Required rate of return is the minimum return that an investor demands for a specific asset based on its riskiness. This is the minimum interest rate at which investors will be willing to invest or lenders will be willing to lend their money.

Opportunity Cost  

The required rate of return also reflects the opportunity cost of forgoing the next best investment. Opportunity cost is what a person sacrifices when he chooses one option over the other. Say you decided to spend the money (current consumption). If investing that money instead of consuming earned you an interest rate of 6%, then 6% is the opportunity cost.

Discount Rate

The interest rates are also referred to as the discount rate is used to calculate the present value of future cash flows. If you are expecting to receive $1,000 after one year, you will use the discount rate to calculate the present dollar equivalent of that future payment.

Generally, a single discount rate is used for all future period cash flows.

When calculating the intrinsic value of a stock, the investor will apply a discount rate that is based on the risk free rate of return plus some equity risk premium.