What discount rate is used to compute the present value of projected cash flows in a DCF?

What discount rate is used to compute the present value of projected cash flows in a DCF?

• A. Cost of equity
• B. Cost of debt
• C. Unlevered cost of capital
• D. WACC

Answer: (D)

In a DCF you’re valuing the cash flows that belong to the whole firm, not just one type of investor. The rate that matches this is the weighted average cost of capital, or WACC. It blends the cost of equity and the after‑tax cost of debt in the proportions of the firm’s financing, capturing both the risk of the firm’s assets and the tax shield that debt provides. Using only the cost of equity would ignore the debt portion and its impact on risk and returns; using only the cost of debt would miss what equity investors require. An unlevered cost of capital is the rate you’d use if you were discounting cash flows as if the firm had no debt, which is a different setup. For standard enterprise-valued DCFs, discounting FCFF with WACC gives the correct measure of the firm’s value.

In a DCF you’re valuing the cash flows that belong to the whole firm, not just one type of investor. The rate that matches this is the weighted average cost of capital, or WACC. It blends the cost of equity and the after‑tax cost of debt in the proportions of the firm’s financing, capturing both the risk of the firm’s assets and the tax shield that debt provides. Using only the cost of equity would ignore the debt portion and its impact on risk and returns; using only the cost of debt would miss what equity investors require. An unlevered cost of capital is the rate you’d use if you were discounting cash flows as if the firm had no debt, which is a different setup. For standard enterprise-valued DCFs, discounting FCFF with WACC gives the correct measure of the firm’s value.