Having projected the company's free cash flow for the next five years, we want to figure out what these cash flows are worth today. That means coming up with an appropriate discount rate that we can use to calculate the net present value (NPV) of the cash flows.
So, how do we figure out the company's discount rate? That's a crucial question, because a difference of just one or two percentage points in the cost of capital can make a big difference in a company's fair value.

A wide variety of methods can be used to determine discount rates, but in most cases, these calculations resemble art more than science. Still, it is better to be generally correct than precisely incorrect, so it is worth your while to use a rigorous method to estimate the discount rate.
A good strategy is to apply the concepts of the weighted average cost of capital (WACC). The WACC is essentially a blend of the cost of equity and the after-tax cost of debt. Therefore, we need to look at how cost of equity and cost of debt are calculated.

Unlike debt, which the company must pay at a set rate of interest, equity does not have a concrete price that the company must pay. But that doesn't mean that there is no cost of equity. Equity shareholders expect to obtain a certain return on their equity investment in a company. From the company's perspective, the equity holders' required rate of return is a cost, because if the company does not deliver this expected return, shareholders will simply sell their shares, causing the price to drop.
Therefore, the cost of equity is basically what it costs the company to maintain a share price that is satisfactory (at least in theory) to investors. The most commonly accepted method for calculating cost of equity comes from the Nobel Prize-winning capital asset pricing model (CAPM),

Cost of Equity (R_e) = R_f + β (R_m-R_f).

• Rf - Risk-Free Rate - This is the amount obtained from investing in securities considered free from credit risk, such as long-term overnment bonds from developed countries, UK 30-year gilts or US long bond. The riskfree rate that you use in an analysis should be in the same currency that your cashflows are estimated in. In other words, if your cashflows are in U.S. dollars, your riskfree rate has to be in U.S. dollars as well.
  The risk free rate should be measured consistently with how the cash flows are measured. Thus, if cash flows are estimated in nominal US dollar terms, the risk free rate will be the US treasury bond rate.
  Under conditions of high and unstable inflation, valuation is often done in real terms. Effectively, this means that cash flows are estimated using real growth rates and without allowing for the growth that comes from price inflation.
• Beta - This measures how much a company's share price moves against the market as a whole. A beta of one, for instance, indicates that the company moves in line with the market. If the beta is in excess of one, the share is exaggerating the market's movements; less than one means the share is more stable. Occasionally, a company may have a negative beta (e.g. a gold mining company), which means the share price moves in the opposite direction to the broader market. (To learn more, see Beta: Know The Risk.)
  Assets that are riskier than average will have betas that are greater than 1 and assets that are less riskier than average will have betas that are less than 1. The riskless asset will have a beta of 0.
  The betas for UK companies can be found on the Monyeam website in the Company Zone area by entering the EPIC code of the desired company.

  In the Capital Asset Price Model (CAPM), the beta of an investment is the risk that the investment adds to a market portfolio. In the APM and Multi-factor model, the betas of the investment relative to each factor have to be measured.
  There are three approaches available for estimating these parameters. The first is to use historical data on market prices for individual investments. The second is to estimate the betas from the fundamental characteristics of the investment. The third is to use accounting data. .

  • Historical Market Betas
  • Fundamental Betas
  • Accounting Betas
• (Rm - Rf) = Equity Market Risk Premium - The equity market risk premium (EMRP) represents the returns investors expect, over and above the risk-free rate, to compensate them for taking extra risk by investing in the stock market. In other words, it is the difference between the risk-free rate and the market rate. It is a highly contentious figure. Many commentators argue that it has gone up due to the notion that holding shares has become riskier.
  The rate established by adding a expected risk premium to the risk-free rate in order to determine the present value of a risky investment.
  The risk premium being the reward for holding the risky market portfolio rather than the risk-free asset. The spread between Treasury and non-Treasury bonds of comparable maturity.
  For the UK studies of long term premia give 4.6 + 1.97 for the pessimistic and for the optimistic 4.6 - 1.97

  If the investment is in a foreign country then country risk also comes into play.

In the capital asset pricing model, where there is only one source of market risk. This risk premium becomes the premium that investors would demand when investing. In multi-factor models, there are multiple risk premiums, each one measuring the premium demanded by investors for exposure to a specific risk factor. .

Once the cost of equity is calculated, adjustments can be made to take account of risk factors specific to the company, which may increase or decrease the risk profile of the company. Such factors include the size of the company, pending lawsuits, concentration of customer base and dependence on key employees. Adjustments are entirely a matter of investor judgement and they vary from company to company.

Compared to cost of equity, cost of debt is fairly straightforward to calculate. The rate applied to determine the cost of debt (Rd) should be the current market rate the company is paying on its debt.
If the company is not paying market rates, an appropriate market rate payable by the company should be estimated.

As companies benefit from the tax deductions available on interest paid, the net cost of the debt is actually the interest paid less the tax savings resulting from the tax-deductible interest payment. Therefore, the after-tax cost of debt is Rd x (1 - corporate tax rate).

The WACC is the weighted average of the cost of equity and the cost of debt based on the proportion of debt and equity in the company's capital structure. The proportion of debt is represented by D/V, a ratio comparing the company's debt to the company's total value (equity + debt). The proportion of equity is represented by E/V, a ratio comparing the company's equity to the company's total value (equity + debt).
The WACC is represented by the following formula:

WACC = Re x E/V + Rd x (1 - corporate tax rate) x D/V.

Llet's suppose The Widget Company has a capital structure of

• 40% debt and
• 60% equity,
• with a tax rate of 30%.

The WACC comes to 10.64%. So, rounded up to the nearest percentage, the discount rate for The Widget Company would be 11% (see below.

WACC for The Widget Company
Cost of Equity = Re = Rf + Rp*Beta = .05 + 1.3*.08 = .154
Cost of Debt = Rd = Rf*(1-tax rate) = .05*.07 = .035
WACC = Re*E/V + Rd*D/V = .154*.6 + .035*.4 = 10.64

A low inflation environment generates falling interest rates and therefore reduces the WACC of companies. On the other hand, concerns over accounting irregularities such as at Enron and WorldCom have increased the perceived risk of equity investments.

Be warned: the WACC formula seems easier to calculate than it really is. Rarely will two people derive the same WACC, and even if two people do reach the same WACC, all the other applied judgements and valuation methods will likely ensure that each has a different opinion regarding the components that comprise the company's value.