Discount Rate (WACC) Derivation

The DCF does two things: it projects unlevered free cash flows and then discounts them back to today at a rate that reflects the risk of those cash flows. That discount rate is almost always the Weighted Average Cost of Capital (WACC).

WACC is the required return that all capital providers collectively demand — equity investors, bondholders, term lenders and other debt providers. If your WACC is wrong, your valuation can be off by tens or hundreds of millions. That's why interviewers care so much about how you justify each WACC input, not just the final number.

WACC is literally a weighted average of the after-tax cost of debt and the cost of equity. The first question is: what weights do we use? In IB models, we almost always use a target market-value capital structure, not book values.

Think of capital structure as the mix of funding that supports the enterprise: how much comes from common equity vs. debt (and occasionally preferred or minorities). Using market values matters because it reflects what investors are actually paying today, not historical accounting numbers buried in the balance sheet.

A realistic target capital structure does two things for your DCF: it drives the WACC weights (E/V and D/V) and it tells a story about leverage. A highly levered structure lowers the weight on equity (which is expensive) but increases financial risk; a more conservative structure does the opposite. As an analyst, your job is to pick weights that are consistent with where similar companies trade and how your client actually plans to finance the business.

Equity Value (market):    $800m
Net Debt (market):         $400m
Enterprise Value:        $1,200m

Equity Weight (E/V):     800 / 1,200 = 66.7%
Debt Weight (D/V):       400 / 1,200 = 33.3%

WACC = (E / V) × Ke + (D / V) × Kd × (1 − T)

E/V = Equity Value / (Debt Value + Equity Value)
D/V = Debt Value / (Debt Value + Equity Value)
V   = Debt Value + Equity Value

In most practical DCFs, the Cost of Equity is estimated using the Capital Asset Pricing Model (CAPM):

In interviews, you should be able to articulate each term cleanly:

• Rf: Yield on a long-term government bond in the company's currency (often 10-year).
• ERP: Equity risk premium — extra return investors demand for owning equities over risk-free bonds.
• β (Beta): Measure of how sensitive the stock is to the overall market; captures business & financial risk.
• Size & other premia: Adjustments sometimes used for small companies or country risk.

In real life, a company's regression beta (from Bloomberg) can be noisy, distorted by one-off events, or not available (private companies). That's why bankers often use a bottom-up beta based on peers.

In real life, a company's regression beta (from Bloomberg) can be noisy, distorted by one-off events, or not available (private companies). That's why bankers often use a bottom-up beta based on peers.

Unlevered Beta (β_u) = Levered Beta / [1 + (1 - T) × (D/E)]
Relevered Beta (β_L) = β_u × [1 + (1 - T) × (D/E_target)]

Peer     Levered β   D/E   T
--------------------------------
A           1.30      0.5  25%
B           1.10      0.3  25%
C           1.20      0.4  25%

Many academic resources add size premia and other adjustments on top of CAPM to account for small-cap or illiquid companies. In practice, bankers use these thoughtfully — not by default.

The Cost of Debt is the interest rate the company pays on its borrowings, adjusted for tax shields. You rarely use the coupon rate; instead, you care about the current yield / marginal borrowing cost.

Because interest expense is tax-deductible in most jurisdictions, the effective cost of debt is lower than the pre-tax interest rate. That's why WACC uses after-tax cost of debt. In other words, the tax shield from interest makes debt cheaper than it looks on the term sheet.

Conceptually, there are two ways to handle this in a DCF: (1) forecast explicit interest and tax savings in the cash flows, or (2) keep cash flows unlevered (before interest) and capture the tax shield in the discount rate by using the after-tax cost of debt in WACC. Investment banking DCFs almost always use option (2), which is why you only see the (1 − T) term in the debt piece of the WACC formula, not in the equity piece.

Example:
Pre-Tax Cost of Debt   = 6.0%
Tax Rate               = 25%
After-Tax Cost of Debt = 6.0% × (1 − 0.25) = 4.5%

Imagine you're valuing a private industrial company with $150m EBITDA and no traded bonds. You still need a defensible WACC. Here is how a first-year analyst might structure it.

These are the kinds of questions you should be able to answer clearly in a first-round or superday. Try answering each out loud before reading a model solution.