When we discount future cash flows, we need a rate that reflects both the risk and opportunity cost of investing in a company. This rate is called the discount rate or discount factor.

It answers a fundamental question: How much less is a future dollar worth to us today?

The discount rate plays a critical role in DCF because:

• It shrinks future values to reflect time and uncertainty;

• It's the lens through which we evaluate investments: the higher the risk, the higher the rate.

$\text{Discount Rate} = (\%\text{Equity} \times \text{Cost of Equity}) + (\%\text{Debt} \times \text{Cost of Debt} \times (1 - \text{Tax Rate}))$

For instance, a tech startup with volatile revenue streams might have a discount rate of 15–20%, while a stable utility company might be closer to 6–8%.

When valuing a company as a whole (using unlevered free cash flow), the discount rate is usually calculated based on two pillars:

1. Cost of Equity: the return expected by shareholders. It reflects market risk and can be estimated using models like CAPM (Capital Asset Pricing Model);

2. Cost of Debt: the effective rate a company pays on its borrowed funds, adjusted for the tax shield (because interest is tax-deductible).

Together, they are combined into the Weighted Average Cost of Capital (WACC), which we'll explore further in later chapters.

The discount rate is not arbitrary—it reflects the expectations of the market and the specific risks of the business. Mastering how it's calculated and applied is essential for building accurate valuation models.