The forecast cash flows and the terminal value in a DCF valuation model are discounted to present value using a discount rate that is commensurate with the risk associated with their generation. Since the financing of the operational business is provided by both debt and equity then the discount rate used is the weighted average cost of capital or WACC. The weighted average cost of capital can be summarized as follows:
The weighted average cost of capital reflects the return required by the providers of capital to compensate for the risk profile of the underlying asset. Therefore, it is a market-based measure. The components of the capital structure included in WACC should also be consistent with items considered to be financing when calculating free cash flow.
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