When using a DCF method with free cash flows to the firm (FCFF) to value a firm, what measure should we use for the discount rate?

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BlackTom AI · Accepted Answer

When valuing a firm with free cash flows to the firm (FCFF), the discount rate should reflect the overall cost of capital to the entire firm, not just a single source of financing.

Option 1: cost of equity. This would reflect only the return required by shareholders on equity financing and does not account for debt financing or the firm's overall capital structure. Using only the cost of equity would ignore the firm’s leverage and the tax advantages of debt in FCFF valuation.

Option 2: yield to maturity. YTM pertains to valuing a specific bond or debt instrument, not a firm-wide cash flow stream like FCFF. It does not incorporate the mix of debt and equity or the tax shield effects embedded in the firm’s financing.

Option 3: WACC. The weighted average cost of capital combines the costs of equity and debt, weighted by their proportions in the firm’s target capital structure, and typically incorporates after-tax cost of debt. This aligns with FCFF, which represents cash flows available to all providers of capital; discounting FCFF with WACC captures the overall opportunity cost of investing in the firm as a whole.

Option 4: cost of debt. The cost of debt isolates the expense of borrowing, ignoring the equity portion and the equity holders’ required return. Relying only on debt cost would undervalue the required return for the entire capital structure and misprice FCFF.

In summary, FCFF is discounted at the firm’s overall cost of capital, i.e., the WACC, since FCFF represents cash flows available to all capital providers and the discount rate should reflect the blended risk and cost of financing the firm.

MSB-250-300-002 Proctored Final Exam

When using a DCF method with free cash flows to the firm (FCFF) to value a firm, what measure should we use for the discount rate?

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