When conducting discounted cash flow (DCF)valuation using free cash flow to equity, the appropriate discount rate is:
A)Weighted average cost of capital of the target firm
B)Risk-adjusted cost of equity of the target firm
C)Risk-adjusted cost of equity of the acquiring firm
D)Weighted average cost of capital of the acquiring firm

Question

Quizplus · Accepted Answer

When using free cash flow to equity in DCF valuation, the appropriate discount rate would be the risk-adjusted cost of equity of the target firm. This is because we are specifically valuing the equity of the target firm and not taking into consideration the debt or other financing sources. The risk-adjusted cost of equity takes into account the systematic risk of the target firm and is a more appropriate measure for discounting the future cash flows to present value. The weighted average cost of capital (WACC) takes into account the cost of both equity and debt financing and would not be suitable for valuing just the equity portion. The risk-adjusted cost of equity of the acquiring firm would also not be applicable, as we are valuing the target firm and not the acquiring firm.

When Conducting Discounted Cash Flow (DCF)valuation Using Free Cash Flow