What you will learn
- Explain what the discount rate represents and why risk raises it
- Calculate the weighted average cost of capital (WACC)
- Understand why the after-tax cost of debt uses one minus the tax rate
- See why a small change in the discount rate can move a valuation a lot
The second ingredient of a DCF is the discount rate, the number that converts future cash flows into today's value. It can look like a technical footnote, but it is one of the most argued-over inputs in valuation, because it captures how much risk you think the cash flows carry. This is the same discounting from Unit 1, now with a rate you have to justify.
WACC explained (The Finance Storyteller)
A short, clear intro to the weighted average cost of capital as the rate used to discount a company's cash flows. Watch this before the formula below.
What the discount rate represents
The discount rate captures two things at once. First, the opportunity cost of capital, meaning the return investors could earn elsewhere on a comparable investment. Second, the riskiness of the specific cash flows being valued. Riskier, less certain cash flows deserve a higher discount rate, which lowers their present value. Safer, more predictable cash flows warrant a lower rate, which raises their present value. In short, the discount rate is the price of risk and time combined into a single percentage.
WACC: the cost of all the company's capital
When valuing the entire firm, the standard discount rate is the weighted average cost of capital, or WACC. A company is financed by two kinds of capital, equity from shareholders and debt from lenders, and each has its own cost. WACC blends them in proportion to how much of each the company uses.
- WACC equals (E divided by V) times the cost of equity, plus (D divided by V) times the cost of debt times (1 minus the tax rate).
- Here E is the market value of equity, D is the market value of debt, and V is the total of the two.
- The cost of debt is multiplied by (1 minus the tax rate) because interest payments are tax-deductible, which lowers their effective cost. This is called the tax shield.
Key terms
- Discount rate
- The rate that converts future cash flows to present value, reflecting risk and opportunity cost.
- WACC
- The weighted average cost of a company's equity and debt, the usual discount rate for the whole firm.
- Cost of equity
- The return shareholders require, often estimated with the Capital Asset Pricing Model.
- Tax shield
- The reduction in the cost of debt because interest is tax-deductible, applied via one minus the tax rate.
Calculating WACC
A company is 60 percent equity and 40 percent debt by value. Its cost of equity is 12 percent, its cost of debt is 6 percent, and its tax rate is 25 percent. What is its WACC?
- Weight the equity cost. 0.60 times 12 percent is 7.2 percent.
- Weight the after-tax debt cost. 0.40 times 6 percent times (1 minus 0.25) is 0.40 times 6 percent times 0.75, which is 1.8 percent.
- Add them. 7.2 percent plus 1.8 percent is 9.0 percent.
Why it matters: WACC blends the two costs by how much of each the company uses. The tax shield makes debt cheaper than its stated rate.
Calculate WACC
A company is 70 percent equity and 30 percent debt by value. Its cost of equity is 10 percent, its cost of debt is 5 percent, and its tax rate is 20 percent. What is its WACC, as a percent?
Where the cost of equity comes from
The cost of debt is fairly easy to observe from the interest rates a company pays. The cost of equity is harder, because shareholders have no contractual return. It is most often estimated with the Capital Asset Pricing Model, which Unit 6 covers in full. In brief, that model says the cost of equity equals the risk-free rate plus the company's beta times the equity risk premium, where beta measures how much the stock moves with the overall market. The riskier the stock relative to the market, the higher its cost of equity.
The discount rate is where your view of risk enters the valuation. Get it wrong and everything downstream is wrong with it.
WACC formula and intuition (Breaking Into Wall Street)
A deeper look at the WACC formula and how each piece is estimated. Good once the basic calculation makes sense.
Why small changes matter so much
Because future cash flows are divided by the discount rate compounded over many years, even a small change in the rate can swing the valuation a lot, especially for the distant cash flows and the terminal value. Moving the discount rate from 8 percent to 10 percent can knock a large fraction off a company's estimated worth. This extreme sensitivity is exactly why the rate is so debated, and why honest analysts test a range of rates rather than pretending to know the one true number.
Which company gets the higher rate?
You are valuing two companies. One is a stable regulated utility with steady, predictable cash flows. The other is an early-stage biotech with highly uncertain cash flows. Which deserves the higher discount rate, and what does that do to its valuation?
The riskier biotech deserves a higher discount rate, which lowers the present value of its cash flows. The discount rate is how risk shows up in a valuation.Match the WACC pieces
Pair each part of the WACC formula with what it means.
You have two of the three ingredients. The last piece captures everything beyond your explicit forecast, and for many companies it is the biggest part of the answer: the terminal value.