What do you usually use for the discount rate?

What do you usually use for the discount rate?

• A. WACC, though you might also use Cost of Equity depending on how you've set up the DCF
• B. IRR
• C. Payback period
• D. Target rate of return

Answer: (A)

Discount rate in a DCF is chosen to reflect both risk and how the project is financed. The usual choice is the weighted average cost of capital, since it combines the cost of debt and equity in the company's actual capital structure and accounts for the tax shield on debt. This rate is appropriate when discounting the firm’s unlevered cash flows because it represents the return required by all providers of capital. If the analysis is set up to value equity cash flows or uses a different financing mix, you might use the cost of equity instead, since that isolates the return demanded by equity holders. Other metrics aren’t used as the discount rate in a standard DCF. IRR is the rate that makes NPV zero for the given cash flows, not the rate you apply to discount them. The payback period ignores the time value of money. A target rate of return is a hurdle for decision-making, not the discount rate unless it’s aligned with the capital costs in your setup.

Discount rate in a DCF is chosen to reflect both risk and how the project is financed. The usual choice is the weighted average cost of capital, since it combines the cost of debt and equity in the company's actual capital structure and accounts for the tax shield on debt. This rate is appropriate when discounting the firm’s unlevered cash flows because it represents the return required by all providers of capital.

If the analysis is set up to value equity cash flows or uses a different financing mix, you might use the cost of equity instead, since that isolates the return demanded by equity holders.

Other metrics aren’t used as the discount rate in a standard DCF. IRR is the rate that makes NPV zero for the given cash flows, not the rate you apply to discount them. The payback period ignores the time value of money. A target rate of return is a hurdle for decision-making, not the discount rate unless it’s aligned with the capital costs in your setup.