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Is there an intuitive explanation of why, in DCF modeling, the discount rate should be interpreted as the minimum rate of return?

This doesn't make sense to me because I think of the NPV as "what all the future cash flows should be, pulled to the present, if the universe evolves naturally". And if the universe just evolves, it has nothing to do with me, or what I want, or what I would accept minimally as the rate of return.

To me, intuitively, this rate should be the rate of inflation... Is my understanding of NPV incorrect? Please help me point out the flaw in my reasoning.

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The discount rate (for interbank trades) is broadly treated as the risk free rate. So at worst you could obtain this rate for no risk, making it the minimum rate of return. No instrument should yield less than this.

NPV is not about how the universe evolves, it's about the fair value of something today. If you were to dispose of an asset, or make a price, this is the value of the thing to you today. If you needed to fund a forward cash flow, you could borrow that cash now (using your discount function), and then invest it at a fixed risk-free rate to that maturity, and you have hedged away the rate risk to get a known cost now of funding that cash flow.

NPV is not about waiting, it is about current fair value.

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  • $\begingroup$ Thank you for your answer, it makes more sense to me now! Just to be absolutely explicit, is it correct to say that the discounting rate is the rate that makes one indifferent between the following two scenarios: 1) having this financial instrument, with its future cash flow, and also with its associated risks of default, etc 2) having the lump sum NPV amount of cash, now, with certainty ? $\endgroup$
    – anon_student
    Feb 9, 2018 at 0:31
  • $\begingroup$ @anon_student: Yes. Sometimes past trades are 'torn up', i.e. you agree a price with the counterparty to settle and drop the whole contract, for which you would expect to pay/receive approximately the NPV. Similarly if your counterparty disappeared, that would be the amount you would expect it to cost to recreate the position. $\endgroup$
    – Phil H
    Feb 9, 2018 at 8:42

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