To determine the discount rate for a DCF, calculate the weighted average cost of capital (WACC): find the cost of equity using the Capital Asset Pricing Model, find the after-tax cost of debt, and blend the two by the company’s market-value proportions of equity and debt. The result is the minimum return that justifies tying capital up in the business, and it becomes the rate you use to bring future free cash flows back to present value. A one-percentage-point error can move a valuation by millions, so each input deserves care.
The blended formula is:
WACC = (E ÷ V) × Cost of Equity + (D ÷ V) × After-Tax Cost of Debt
E is the market value of equity, D is total debt, and V is E + D.
Inputs You Need Before Any Formula
Six data points drive the whole calculation. Pull them all from the same reporting period and convert every percentage to a decimal before it enters a formula.
- Risk-free rate: the yield on 10-year U.S. Treasury notes, published on the Treasury’s daily yield curve page. As of early 2026, that yield sits around 4.28%.1U.S. Department of the Treasury. Daily Treasury Rate Archives
- Equity beta: how much a stock moves relative to the broader market. A beta of 1.0 tracks the market; above 1.0 is more volatile, below 1.0 is calmer. Financial data providers such as Yahoo Finance and Bloomberg publish this for public companies.
- Equity risk premium: the extra return investors expect from stocks over risk-free bonds. One widely referenced implied estimate, derived from S&P 500 cash flows and prices, puts the U.S. figure at roughly 4.2% in early 2026. Historical averages tend to run 4% to 6% depending on period and method.
- Market value of equity: current share price multiplied by shares outstanding.
- Total debt: short-term borrowings plus long-term debt from the most recent balance sheet, found in the company’s Form 10-K filed with the SEC.2U.S. Securities and Exchange Commission. Form 10-K
- Cost of debt and effective tax rate: divide total interest expense by average total debt for the cost of debt. The effective tax rate appears in the income tax footnote and often differs from the 21% statutory federal rate.3Office of the Law Revision Counsel. 26 U.S. Code 11 – Tax Imposed
Cost of Equity Using CAPM
CAPM gives the return equity investors require for holding a specific stock. The formula:
Cost of Equity = Risk-Free Rate + (Beta × Equity Risk Premium)
Multiply beta by the equity risk premium first, then add the risk-free rate. Take a company with a beta of 1.2 and an equity risk premium of 4.2%. That product is 5.04%. Add a 4.28% risk-free rate and the cost of equity is 9.32%. Below that threshold, projected returns don’t compensate equity holders for the risk they’re taking.
Adjust Beta for Capital Structure
The beta from a data provider is a levered beta: it reflects both business risk and financial leverage. If you’re borrowing a beta from a peer whose debt load differs from your target’s, strip out the leverage effect and re-lever to your target’s capital structure. The standard tool is the Hamada equation.
Unlever first:
Unlevered Beta = Levered Beta ÷ [1 + (1 − Tax Rate) × (Debt ÷ Equity)]
Then re-lever:
Relevered Beta = Unlevered Beta × [1 + (1 − Tax Rate) × (Target Debt ÷ Target Equity)]
Say the peer has a levered beta of 1.3, a 21% tax rate, and a debt-to-equity ratio of 0.5. Unlevered, that beta is about 0.93. If your target’s debt-to-equity is 0.3, re-levering produces roughly 1.15 instead of the peer’s 1.3. The gap moves the cost of equity by more than half a percentage point. Skipping this step is one of the most common WACC errors, especially in capital-intensive industries where leverage varies widely across peers.
Choosing an Equity Risk Premium
Practitioners disagree here, and the choice moves your answer. Historical averages measure the actual spread between stock and Treasury returns over decades, and often land in the 5% to 6% range using arithmetic means of long-run U.S. data. Implied estimates work backward from current prices and expected cash flows to derive the return the market is pricing in now. Implied numbers tend to be lower and more responsive to current conditions.
There is a separate debate over arithmetic versus geometric means for historical premiums. Arithmetic means produce higher figures; geometric means compound the returns and produce lower ones. Some finance textbooks argue for the arithmetic figure, others recommend something between the two. The gap can be a full percentage point. Pick a method and use it consistently across valuations.
Adjustments Beyond Textbook CAPM
Basic CAPM works reasonably well for large, liquid public companies. For smaller firms it tends to understate the required return, so practitioners use a modified CAPM that adds one or two premiums:
Cost of Equity = Risk-Free Rate + (Beta × Equity Risk Premium) + Size Premium
Decades of market data show smaller companies deliver higher returns than CAPM alone predicts, likely reflecting liquidity risk and operating uncertainty. Published studies group companies by market cap and report the excess return above CAPM’s prediction. For companies under $500 million in market capitalization, the size premium can add 3% to 6%.
Some analysts include a further company-specific risk premium for factors that neither beta nor size captures: customer concentration, key-person dependence, pending litigation. This adjustment is subjective; experienced valuators keep it in a 0% to 3% band and document each point they add. Overstating it depresses the valuation just as misleadingly as ignoring real risk inflates it.
After-Tax Cost of Debt
Debt is cheaper than equity because interest is tax-deductible. Under the general rule in the tax code, businesses deduct interest paid on indebtedness from taxable income, reducing the effective cost of borrowing.4Office of the Law Revision Counsel. 26 USC 163 – Interest The formula:
After-Tax Cost of Debt = Interest Rate × (1 − Effective Tax Rate)
A company borrowing at 5% with a 25% effective tax rate has an after-tax cost of 5% × 0.75 = 3.75%. The effective rate reflects the 21% federal statutory rate plus applicable state corporate taxes, which range from about 2% to nearly 12% across the 44 states that impose them, adjusted for credits and deductions.
The Interest Deduction Has a Ceiling
Section 163(j) of the Internal Revenue Code caps how much business interest a company can deduct in any year. Deductible interest cannot exceed business interest income plus 30% of adjusted taxable income.5Internal Revenue Service. Questions and Answers About the Limitation on the Deduction for Business Interest Expense For highly leveraged companies, the full tax shield may not materialize, and the true after-tax cost of debt is higher than the simple formula suggests.
For tax years beginning after 2024, adjusted taxable income no longer adds back depreciation and amortization, tightening the limit for capital-intensive businesses. Disallowed interest carries forward, but the deferral erodes present value. If 163(j) is likely to bind, use a blended effective interest rate that accounts for the partial loss of the shield rather than assuming full deductibility.
Blending Into WACC: A Worked Example
Weight each cost by its share of total capital. Take a company with a $600 million market cap and $400 million in debt, so total capital is $1 billion. The equity weight is 0.60, the debt weight is 0.40. With a 9.32% cost of equity and 3.75% after-tax cost of debt:
(0.60 × 9.32%) + (0.40 × 3.75%) = 5.59% + 1.50% = 7.09%
That 7.09% is the discount rate for the DCF.
Use Market Values for the Weights
Market values reflect what investors actually paid for their claims. Book values record historical cost and often lag reality by years. Market capitalization gives you equity. For debt, the book value on the balance sheet is a reasonable proxy for market value as long as the company isn’t distressed. Distressed debt trades below face value, and using book value then overstates the debt weight and understates WACC. If the company has publicly traded bonds, use their market prices for a true figure.
Applying the Rate in Your DCF
Once you have WACC, discount each projected free cash flow back to present value:
Firm Value = FCF₁ ÷ (1 + WACC)¹ + FCF₂ ÷ (1 + WACC)² + … + FCFₙ ÷ (1 + WACC)ⁿ
A $100 million cash flow three years out, discounted at 7.09%, has a present value of about $81.3 million. The further out, the deeper the discount.
Pair WACC with the right cash flow. WACC is used with free cash flow to the firm, also called unlevered free cash flow: cash available to all capital providers before debt payments. Discounting free cash flow to equity (which already subtracts interest and debt repayments) by WACC double-counts the cost of debt. Discounting unlevered cash flow by WACC gives you enterprise value; subtract net debt to arrive at equity value.
Terminal Value Magnifies Discount Rate Error
Most models project five to ten years of specific cash flows and use a terminal value for everything beyond. Terminal value usually accounts for the majority of enterprise value, so discount rate accuracy matters even more there. The perpetuity growth formula:
Terminal Value = Final Year FCF × (1 + Growth Rate) ÷ (WACC − Growth Rate)
The perpetuity growth rate should not exceed long-term GDP growth, typically 2% to 3%. WACC sits in the denominator, so small shifts in the spread between WACC and the growth rate move terminal value sharply. With a 7% WACC and 2.5% perpetuity growth, the denominator is 4.5%. Drop WACC to 6.5% and the denominator becomes 4%, lifting terminal value by more than 12%.
Common Mistakes That Shift the Answer
A stale risk-free rate is surprisingly frequent. The 10-year Treasury yield moves daily, and a six-month-old figure can be off by 50 basis points. Pull the yield the day you run the valuation, or use a recent average at minimum.
Borrowing a peer’s levered beta without adjusting for capital structure bakes the peer’s financing choices into your target’s cost of equity. Run the Hamada step every time the debt loads differ.
Mixing cash flow types breaks the model’s logic. WACC already incorporates the cost of debt, so it belongs with unlevered free cash flow. Discounting equity cash flows by WACC undervalues the business; discounting unlevered cash flows by cost of equity alone overvalues it.
Assuming full interest deductibility for companies near the 163(j) ceiling overstates the tax shield. Where interest expense pushes past 30% of adjusted taxable income, rerun the numbers with a reduced benefit and see how sensitive WACC is to the assumption.