In discounted cash flow analysis, which discount rate is commonly used?

• A. Weighted average cost of capital (WACC).
• B. Cost of debt only.
• C. Inflation rate only.
• D. Tax rate only.

Answer: (D)

In discounted cash flow analysis, you want a rate that reflects the opportunity cost of the capital tied up in the project and the risk of the expected cash flows. The standard choice is the weighted average cost of capital because it combines the costs of all financing sources—debt and equity—into one hurdle rate. The debt portion is used after tax since interest is tax-deductible, which lowers the effective cost of debt and reduces the overall rate. Using only the cost of debt ignores the return required by equity investors, and using inflation or a tax rate alone doesn’t capture either the full cost of financing or the risk of the project. So the common discount rate is the firm's WACC.