In a DCF valuation, which rate is used to discount the forecast unlevered free cash flows to obtain enterprise value?

In a DCF valuation, which rate is used to discount the forecast unlevered free cash flows to obtain enterprise value?

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

Answer: (C)

The rate used is the weighted average cost of capital. Unlevered free cash flow is the cash flow generated by the firm before financing decisions and is available to all providers of capital—both debt and equity. To value the entire firm, you need a discount rate that reflects the risk of the firm’s underlying assets, not the perspective of just debt or just equity. The weighted average cost of capital combines the costs of equity and debt (adjusted for taxes) in proportion to the firm’s capital structure, giving a single rate that matches the risk of the unlevered cash flows. Using the cost of equity would ignore debt and the tax shield, using the cost of debt would ignore equity risk, and the internal rate of return is a project-specific measure, not the firm-wide rate for enterprise valuation.

The rate used is the weighted average cost of capital. Unlevered free cash flow is the cash flow generated by the firm before financing decisions and is available to all providers of capital—both debt and equity. To value the entire firm, you need a discount rate that reflects the risk of the firm’s underlying assets, not the perspective of just debt or just equity. The weighted average cost of capital combines the costs of equity and debt (adjusted for taxes) in proportion to the firm’s capital structure, giving a single rate that matches the risk of the unlevered cash flows. Using the cost of equity would ignore debt and the tax shield, using the cost of debt would ignore equity risk, and the internal rate of return is a project-specific measure, not the firm-wide rate for enterprise valuation.