Step Two: Calculating the Appropriate Discount Rate
The weighted average cost of capital is typically used as the discount rate for all future free cash flows needed to determine DCF. As discussed in the previous chapter, the equation used to calculate WACC is:
WACC = (cost of debt x (1 – marginal tax rate) x % of debt)
+ (cost of equity x % of equity).
Cost of equity is calculated by using the following equation:
cost of equity = risk-free rate of return + (beta x market risk premium)
Related to our sample DCF, in addition to the financial information listed in the Projected Operating Data, you know the following about Bunyan’s Cut:
- • Its capital structure is 60% debt, 40% equity
- • Its pre-tax cost of debt is 11%
