WACC: the discount rate, demystified

In the DCF lab we waved a hand and used a 12% discount rate. This lab is where that number comes from. It matters more than almost any other single input, because of one brutal fact: most of a business's value sits in cash that arrives years away, and the discount rate is what decides how much that distant cash is worth today. Get the rate a point wrong and a careful valuation can be off by a third.

The right discount rate for a whole-firm cash flow (FCFF) is the weighted average cost of capital — WACC. The name is the recipe: it's the average return demanded by everyone who put money into the business, weighted by how much each contributed. Two groups fund a company — shareholders and lenders — and each wants a different return for a different risk. WACC blends them.

The shape of the formula

Here's the whole thing in one line; the rest of the lab fills in each piece:

WACC = (E/V) × Cost of Equity + (D/V) × Cost of Debt × (1 − tax rate)

• E = market value of equity, D = market value of debt, V = E + D (the total).
• E/V and D/V are the weights — what fraction of funding comes from each source.
• Cost of equity = the return shareholders demand for their risk (we'll get it from CAPM).
• Cost of debt × (1 − tax) = the rate lenders charge, after the tax saving that interest provides.