Discount Rate Selection in Relation to Cash Flows

When discounting cash flows analysts should use the discount rate that is consistent with the type of cash flow being discounted.

A cash flow to equity should be discounted at the required rate of return on equity.

When a cash flow is available to meet the claims of all of a company’s capital providers, the firm’s weighted average cost of capital is the appropriate discount rate.

Question

Which discount rate would most appropriately discount cash flows to equity to estimate the value of equity for a firm?

1. Rate of return on debt.
2. Rate of return on equity.
3. Weighted average cost of capital.

Solution

The correct answer is B.

The rate of return on equity is the discount rate that would be used to discount cash flows to equity to estimate the value of equity of the firm.

A is incorrect. The rate of return on debt is used to estimate the amount of debt repayments that the firm makes on its debt.

C is incorrect. The weighted average cost of capital is used to discount cash flows to the firm to estimate the value of the entire firm.

Reading 21: Return Concepts

LOS 21 (h) Evaluate the appropriateness of using a particular rate of return as a discount rate, given a description of the cash flow to be discounted and other relevant facts.