###### The Backtesting Process

There are three steps in backtesting: strategy design, historical investment simulation, and analysis... **Read More**

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 appropriatelydiscount cash flows to equity to estimate the value of equity for a firm?

- Rate of return on debt.
- Rate of return on equity.
- 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.*