If you use Levered Free Cash Flow, what discount rate should you use?

If you use Levered Free Cash Flow, what discount rate should you use?

• A. WACC
• B. Cost of Debt
• C. Cost of Equity
• D. None

Answer: (C)

Levered Free Cash Flow is the cash flow that remains for equity holders after all debt payments. Because this cash flow is what equity investors care about, the discount rate should reflect the return that equity investors require for this residual risk. That rate is the cost of equity, which captures the risk of the firm from the shareholders’ perspective and aligns with the cash flow that goes to them after debt service. Using the cost of equity keeps the valuation consistent with who actually receives the levered cash flow. Discounting levered cash flow with the firm’s blended rate (the WACC) would mix debt and equity risks inappropriately, since levered cash flow already accounts for debt obligations. Discounting with the cost of debt would ignore the portion of cash flow that goes to equity after debt obligations. So, the appropriate rate is the cost of equity.

Levered Free Cash Flow is the cash flow that remains for equity holders after all debt payments. Because this cash flow is what equity investors care about, the discount rate should reflect the return that equity investors require for this residual risk. That rate is the cost of equity, which captures the risk of the firm from the shareholders’ perspective and aligns with the cash flow that goes to them after debt service.

Using the cost of equity keeps the valuation consistent with who actually receives the levered cash flow. Discounting levered cash flow with the firm’s blended rate (the WACC) would mix debt and equity risks inappropriately, since levered cash flow already accounts for debt obligations. Discounting with the cost of debt would ignore the portion of cash flow that goes to equity after debt obligations.

So, the appropriate rate is the cost of equity.