What discount rate is used in the DCF method for unlevered free cash flow?

• A. Cost of Equity
• B. WACC
• C. Cost of Debt
• D. Market Rate

Answer: (B)

The appropriate discount rate used in the discounted cash flow (DCF) method for unlevered free cash flow is the Weighted Average Cost of Capital (WACC). This is because WACC reflects the average rate of return required by all of a company’s security holders, including both equity investors and debt holders.

Unlevered free cash flow represents the cash flow generated by a company’s operations, independent of its capital structure, meaning it does not take into account interest payments or the cost of debt. By using WACC, the DCF method accounts for the opportunity cost of capital invested in the business. It incorporates the risk of the business as a whole, providing a comprehensive view that includes both debt and equity financing.

In contrast, the cost of equity is only relevant for equity holders and does not represent the total cost of capital for the business. The cost of debt specifically relates to the company’s borrowing costs and does not encompass the broader perspective needed in a DCF analysis. Lastly, market rate is too vague and does not specifically relate to the calculation of a company’s cost of capital. Thus, WACC is the correct choice to measure the required return on unlevered free cash flows effectively.