Discount Rate

Two forces make future money worth less than present money. First, opportunity cost: a dollar today can be invested and grow, so receiving it later means giving up that growth. Second, risk: future cash flows are uncertain, and investors demand extra compensation for that uncertainty. The discount rate bundles both into one number. It is, at its core, the expected return an investor could earn on an alternative investment of equal risk — the opportunity cost of capital. Higher risk → higher discount rate → lower present value.

The discount rate must match the cash flow being discounted. Use WACC when discounting unlevered free cash flow (cash available to all capital providers), because WACC blends the returns required by both debt and equity holders — the result is enterprise value. Use the cost of equity when discounting levered free cash flow (cash available only to shareholders, after interest and debt repayment), producing equity value directly. Using the wrong one is a classic error: discounting unlevered cash flow at the cost of equity double-counts the equity risk and undervalues the firm. For projects, firms sometimes use a 'hurdle rate' above WACC to build in a margin of safety.

The discount rate is the single most powerful lever in a DCF. Because future cash flows are divided by (1 + r) raised to ever-larger powers, even a small change in r compounds dramatically over time — and the terminal value, which often makes up 60-80% of a DCF, is especially sensitive. A 1% move in WACC can change a DCF valuation by 10-20%. This is why every DCF includes a sensitivity table flexing the discount rate against the terminal growth rate, and why interviewers stress-test how you chose your rate.