Which rate is typically used to discount cash flows in a DCF?

Which rate is typically used to discount cash flows in a DCF?

• A. WACC
• B. Cost of debt
• C. Cost of equity
• D. Hurdle rate

Answer: (A)

In a DCF, the discount rate should reflect the opportunity cost of capital for the entire firm, i.e., the return that both debt and equity investors require given the company’s risk. The standard measure for this is the Weighted Average Cost of Capital (WACC), which combines the cost of equity and the after‑tax cost of debt in proportion to their share of the capital structure. Using WACC to discount unlevered cash flows (free cash flow to the firm) ensures the present value accounts for both financing sources and the risk of the overall business. Using the cost of debt would ignore equity holders’ required return, and using the cost of equity would ignore the debt component; a hurdle rate is a target for project approval, not the typical discount rate for a full firm DCF.

In a DCF, the discount rate should reflect the opportunity cost of capital for the entire firm, i.e., the return that both debt and equity investors require given the company’s risk. The standard measure for this is the Weighted Average Cost of Capital (WACC), which combines the cost of equity and the after‑tax cost of debt in proportion to their share of the capital structure. Using WACC to discount unlevered cash flows (free cash flow to the firm) ensures the present value accounts for both financing sources and the risk of the overall business. Using the cost of debt would ignore equity holders’ required return, and using the cost of equity would ignore the debt component; a hurdle rate is a target for project approval, not the typical discount rate for a full firm DCF.