DCF Analysis: Calculating the Discount Rate

Now that we’ve calculated ACME Corp.’s free cash flow over the next five years, it’s time to figure out what the cash flows are worth today. To do that, we need an appropriate discount rate, which we’ll use to calculate the net present value (NPV) of the cash flows.

Weighted Average Cost of Capital - WACC

There are a number of methods that can be used to determine discount rates. A good approach – and the one we’ll use in this tutorial – is to use the weighted average cost of capital (WACC) – a blend of the cost of equity and after-tax cost of debt.

A company has two primary sources of financing – debt and equity – and, in simple terms, WACC is the average cost of raising that money. WACC is calculated by multiplying the cost of each capital source (debt and equity) by its relevant weight, and then adding the products together to determine the WACC value:

Where:

Re = cost of equity

Rd = cost of debt

E = market value of the firm’s equity

D = market value of the firm’s debt

V = E + D

E/V = percentage of financing that is equity

D/V = percentage of financing that is debt

Tc = corporate tax rate

When calculating a firm's WACC,  the first step is to determine what proportion of a firm is financed by equity and what proportion is financed by debt by entering the appropriate values into the   and  components of the equation. Next, the proportion of equity () is multiplied by the cost of equity (Re); and the proportion of debt ( ) is multiplied by the cost of debt (Rd).

The debt side of the equation ( * Rd) is then multiplied by (1 - Tc) to get the after-tax cost of debt (there is a tax shield associated with interest). The final step is to add the equity side of the equation to the debt side of the equation to determine WACC.

To calculate WACC for ACME Corp., we’ll assume the following financials:

Equity = $80M

Debt = $20M

Re = 12.5%

Rd = 6%

Tax rate = 30%

To find WACC, we’ll enter the values into the equation and solve:

The WACC for ACME Corp., then, is 10.84%, and we’ll go ahead and round up to 11%.

Keep in mind: Because the WACC calculation takes a long time, many investors prefer to use online stock analysis tools to find the number.

Next, we’ll calculate a fair value for ACME Corp.