Discount Rate

DCF is based on the principle that the value of a firm is equal to the value of its expected future cash flows, discounted at a rate that reflects the time value of money and the risks associated with those cash flows. The discount rate, therefore, converts an expected future cash flow of an asset into an amount that an investor would be willing to pay on the valuation date to gain the opportunity to earn those future cash flows.

WACC

The most widely accepted method of determining the discount rate is based on the weighted average cost of capital or WACC. The WACC is the average cost of financing a company or an asset across all financing sources. It is typically based on the weighted average of the (1) cost of debt and (2) cost of equity, but if other financing sources are used, such as preferred debt, they should be included as well.

Cost of Debt

The cost of debt, in a valuation context, is the marginal interest rate that a company pays on its unsecured debt obligations. Because interest is deductible, the relevant measure is the after-tax cost of debt.

Cost of Equity

The cost of equity is the expected rate of return required by investors to bear the risk of investing in a firm’s equity. There are two components to the cost of equity: (i) the time value of money and (ii) compensation for the riskiness of the equity cash flows.

Time Value of Money

The time value of money reflects the concept that, even in a risk-free environment, a dollar today is worth more than a dollar tomorrow. The time value of money is the difference in value between having a dollar today and receiving the same dollar, with certainty, in the future. Because it compensates only for waiting, but not for risk, it is often called the risk-free rate, and, when valuing assets denominated in U.S. dollars, the yield on U.S. Treasuries is often used. The risk-free rate is the first component of the cost of equity.

Risks

Although the cost of debt reflects the risk of that debt being repaid, the risk component of the discount rate is primarily reflected in the cost of equity. According to widely accepted financial economic theory, compensation only for the non-diversifiable or systematic risk that the asset bears in relation to the market as a whole should be added to the risk-free rate to determine the cost of equity  Arbitrations sometimes utilize the so-called build-up approach, which includes some company-specific risks, even though this approach is not applied in financial economics in the business context. The most commonly applied method for determining the non-diversifiable/systematic risk of an asset is the Capital Asset Pricing Model (CAPM), which determines the extent to which the asset’s value correlates with the market as a whole, often measured by a statistical parameter called “beta.”