Why is WACC the appropriate discount rate for DCF valuation?

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Discounted cash flow (DCF) helps determine the value of an investment based on its future cash flows. … Companies typically use the weighted average cost of capital (WACC) for the discount rate, because it takes into consideration the rate of return expected by shareholders.

What discount rate should I use for DCF?

For SaaS companies using DCF to calculate a more accurate customer lifetime value (LTV), we suggest using the following discount rates: 10% for public companies. 15% for private companies that are scaling predictably (say above \$10m in ARR, and growing greater than 40% year on year)

What is WACC in DCF?

WACC , or Weighted Average Cost of Capital, is a financial metric used to measure the cost of capital to a firm. … WACC is used to determine the discount rate used in a DCF valuation model. The two main sources a company has to raise money are equity and debt.

Why is cost of capital used as discount rate?

The cost of capital refers to the required return necessary to make a project or investment worthwhile. … If it is financed externally, it is used to refer to the cost of debt. The discount rate is the interest rate used to determine the present value of future cash flows in a discounted cash flow (DCF) analysis.

Why is DCF the best valuation method?

One of the most significant advantages of the DCF valuation model is that it returns the closest thing private practices can get to an intrinsic stock market value. By valuing the business based on the discounted value of future cash flow, valuation experts can arrive at a fair market value.

How do you determine the appropriate discount rate?

Discount Rates in Practice

In other words, the discount rate should equal the level of return that similar stabilized investments are currently yielding. If we know that the cash-on-cash return for the next best investment (opportunity cost) is 8%, then we should use a discount rate of 8%.

Why is WACC preferred to book value WACC?

The book value weights are readily available from balance sheet for all types of firms and are very simple to calculate. … Still Market Value WACC is considered appropriate by analysts because an investor would demand market required rate of return on the market value of the capital and not the book value of the capital.

Why is WACC used?

What is WACC used for? The Weighted Average Cost of Capital serves as the discount rate for calculating the Net Present Value (NPV) of a business. It is also used to evaluate investment opportunities, as it is considered to represent the firm’s opportunity cost. Thus, it is used as a hurdle rate by companies.

Why is the WACC used in capital budgeting?

The WACC is used to discount the cash flows associated with capital budgeting proposals to determine their net present values. The components of the cost of capital are common stock, preferred stock, and debt. … However, if too much debt is used, lenders will raise the interest rates charged, which increases the WACC.

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Why is WACC less than cost of equity?

That’s because the total cost of equity and cost of debt are added together, then multiplied by earnings after the tax rate is applied to calculate a weighted average. Therefore, WACC is less than the cost of equity because the after-tax cost of debt is lower than the cost of equity.

Under what conditions the WACC can be used as a discount rate for the cash flows of a specific project?

Securities analysts may use WACC when assessing the value of investment opportunities. For example, in discounted cash flow analysis, one may apply WACC as the discount rate for future cash flows in order to derive a business’s net present value.

Why is WACC not useful?

It gets more difficult to estimate the company’s WACC depending on the company’s capital structure complexities. The WACC is not suitable for accessing risky projects because to reflect the higher risk the cost of capital will be higher.

What is the discount rate in present value?

The discount rate is the investment rate of return that is applied to the present value calculation. In other words, the discount rate would be the forgone rate of return if an investor chose to accept an amount in the future versus the same amount today.