What is generally used to determine the discount rate in a DCF analysis?

The Weighted Average Cost of Capital (WACC) is commonly used to determine the discount rate in a Discounted Cash Flow (DCF) analysis because it reflects the average rate of return that a company is expected to pay its security holders to finance its assets. WACC takes into account the proportion of debt and equity in a company’s capital structure, as well as the costs associated with each component.

WACC is preferred because it provides a more accurate and comprehensive assessment of the risk associated with a business project, reflecting both the cost of equity and the cost of debt based on market conditions. This is critical in DCF analysis since the discount rate is used to calculate the present value of the expected future cash flows, making it essential that the chosen rate adequately reflects the risk involved in those cash flows.

In contrast, other options such as the current inflation rate do not capture the risk or the cost of capital adequately, while historical interest rates may not reflect the current market environment. Market cap size, while indicative of company scale or stability, does not directly inform the cost of capital either. Overall, using WACC directly aligns with the requirements of financial modeling in DCF analyses.