In a DCF model, what is the purpose of the discount factor?

In a DCF model, what is the purpose of the discount factor?

• A. WACC is the discount rate for FCFs to present value
• B. To adjust WACC to future value
• C. To convert FCF to equity value directly
• D. To determine terminal growth rate

Answer: (A)

In a DCF, future cash flows are turned into today’s value by applying a discount rate that reflects both the time value of money and the risk of those cash flows. The discount rate used for unlevered free cash flow to the firm is the weighted average cost of capital (WACC). This rate is applied to each forecasted cash flow to compute its present value, typically using PV = FCF_t / (1 + WACC)^t. WACC represents the return demanded by all providers of capital (debt and equity) given the firm’s risk and capital structure, so it’s the appropriate rate to discount FCFF to arrive at the firm’s value. Why the other ideas don’t fit: discounting to present value, not future value, is the purpose, so adjusting WACC to a future value isn’t correct. Converting free cash flow directly to equity value would require starting from equity cash flows (or adjusting for debt), not the firm-wide FCFF discounting. And the discount rate is separate from the terminal growth rate, which is used to compute the terminal value component, not as the purpose of the discount factor itself.

In a DCF, future cash flows are turned into today’s value by applying a discount rate that reflects both the time value of money and the risk of those cash flows. The discount rate used for unlevered free cash flow to the firm is the weighted average cost of capital (WACC). This rate is applied to each forecasted cash flow to compute its present value, typically using PV = FCF_t / (1 + WACC)^t. WACC represents the return demanded by all providers of capital (debt and equity) given the firm’s risk and capital structure, so it’s the appropriate rate to discount FCFF to arrive at the firm’s value.

Why the other ideas don’t fit: discounting to present value, not future value, is the purpose, so adjusting WACC to a future value isn’t correct. Converting free cash flow directly to equity value would require starting from equity cash flows (or adjusting for debt), not the firm-wide FCFF discounting. And the discount rate is separate from the terminal growth rate, which is used to compute the terminal value component, not as the purpose of the discount factor itself.