BVA Valuation Training / Free Sample Lesson 05
Business Valuation Discount Rate: WACC, Company-Specific Risk & DCF Example
Why can two analysts forecast the same cash flows yet reach different private-business values? Work through a fictional company's cost of equity, discount rate, weighted average cost of capital (WACC), five-year DCF and valuation sensitivity — with transparent assumptions and practice calculations.
Step 01 / Match the cash flow to the discount rate
What Are We Valuing — the Business or Its Equity?
Consider a fictional private services company with a five-year forecast of free cash flow to the firm (FCFF). We want to estimate the operating enterprise value and then reconcile it to a simplified indication of equity value. Every financial amount and discount-rate input below is a classroom assumption, not an observed market benchmark.
Year 1 forecast FCFF
Unlevered cash flow after operating taxes, capital expenditures and investment in operating working capital.
Illustrative target capital
75% equity, 25% interest-bearing debt by assumed market-value capital weights.
Five-year FCFF forecast
Year 1 through Year 5, before debt principal or interest payments.
| Cash-flow measure | Discount rate | Indication |
|---|---|---|
| FCFF — cash flow available to debt and equity capital providers | Weighted average cost of capital (WACC) | Operating enterprise value |
| FCFE — cash flow available to common equity after financing effects | Appropriate cost of equity | Equity value |
Core principle: Match the discount rate, cash-flow definition, capital structure, taxes, currency and valuation premise. Do not discount FCFF at a cost of equity, or subtract interest and debt principal from an FCFF forecast and then discount it at a WACC.
The analysis below assumes a taxable corporate framework, a constant target capital structure, annual end-of-year cash flows, and no separate working-capital settlement. Actual pass-through businesses and changing leverage can require a different treatment of taxes and financing.
Step 02 / Estimate the required return to equity
Build a Private-Company Cost of Equity
One classroom approach extends the capital asset pricing model (CAPM) by considering company size and a separately justified company-specific risk premium. The beta-adjusted equity risk premium represents exposure to systematic market risk; the additional premiums are not automatic.
| Input | Classroom assumption | Interpretation |
|---|---|---|
| Risk-free rate | 4.0% | Assumed currency-consistent long-term reference yield; not a claimed current Treasury rate. |
| Equity risk premium (ERP) | 6.0% | Hypothetical compensation for market equity risk. |
| Equity beta (β) | 1.10 | Assumed sensitivity to systematic market risk. |
| Beta-adjusted ERP | 6.6% | 1.10 × 6.0%. |
| Size premium | 4.0% | Illustrative incremental size-related return; depends on method and evidence. |
| Company-specific risk premium (CSRP) | 3.0% | Judgmental hypothetical adjustment requiring company-specific documentation. |
| Illustrative cost of equity | 17.6% | 4.0% + 6.6% + 4.0% + 3.0% |
Base CAPM component
4.0% risk-free + 1.10 × 6.0% market ERP.
Expanded cost of equity
Includes the assumed 4.0% size and 3.0% specific-risk premiums.
Don't double count: Key-person dependence, customer concentration, volatile margins or supplier exposure may already be captured in the projected cash flows, beta/peer selection or size adjustment. A CSRP is not a fixed published rate for every private company. Explain the incremental risk and its quantitative support before applying one.
Step 03 / Blend debt and equity capital costs
Calculate Weighted Average Cost of Capital (WACC)
WACC combines the return required by equity holders with the after-tax cost of interest-bearing debt, using the assumed market-value target capital weights appropriate for the FCFF model.
Cost of equity (Ke)
Illustrative result from Step 2.
Pre-tax borrowing cost (Kd)
Assumed borrowing cost, not a market or lender quote.
Assumed marginal tax rate
For this simplified tax-deductible-debt example only.
These target percentages describe a hypothetical financing mix for WACC; they do not need to equal the company's current funded-debt balance used later in the enterprise-to-equity bridge. In practice, reconcile that difference and support the chosen long-term weights.
WACC = 14.8875%, rounded to 14.9% for the DCF example
Modeling judgment: The tax shield may not be immediately usable, the applicable tax regime may differ, and the cost of capital can change as leverage changes. The constant 14.9% WACC used in the next step is a simplified classroom assumption, not a rate selected for a real valuation.
Step 04 / Apply the discount rate to projected cash flow
From Five Years of FCFF to Enterprise Value
Next, discount the hypothetical five-year FCFF forecast at 14.9% WACC. The cash flows are after operating taxes and required reinvestment but before interest and debt repayments. Figures below are in US$ thousands ($000).
| Forecast ($000) | Y1 | Y2 | Y3 | Y4 | Y5 |
|---|---|---|---|---|---|
| FCFF | 400 | 430 | 460 | 490 | 520 |
| Discount factor (14.9%) | 0.870 | 0.757 | 0.659 | 0.574 | 0.499 |
| Present value of FCFF | 348 | 326 | 303 | 281 | 260 |
On mobile, swipe the table horizontally to review all five years.
Present value of terminal value = $4,500,840 ÷ 1.1495 ≈ $2,247,470
PV of explicit cash flows
End-of-year discounting of Years 1 through 5.
PV of terminal value
Approximately 59.7% of enterprise value is attributable to terminal value.
Illustrative enterprise value
Unrounded result approximately $3.765 million; not an appraisal conclusion.
Reconcile Enterprise Value to Equity Value
The operating enterprise value is not necessarily the value of the common equity. Assume $95,000 of excess cash, $610,000 of funded debt and no separate debt-like item or closing working-capital true-up.
| Reconciliation | Amount |
|---|---|
| Operating enterprise value | $3,765,000 |
| Add: excess, nonoperating cash | +$95,000 |
| Less: funded debt | −$610,000 |
| Illustrative equity value (rounded) | $3,250,000 |
All component amounts are rounded for display. The precise classroom model yields approximately $3,765,347 operating enterprise value and $3,250,347 equity value. No ownership-interest or marketability discounts, nonoperating asset valuation, transaction expenses or separate working-capital settlement are modeled.
Step 05 / Model uncertainty explicitly
How WACC and Growth Assumptions Change Value
A sensitivity table is more instructive than treating one assumed WACC as an objective fact. Holding all five FCFF forecasts constant, vary WACC and perpetual FCFF growth to observe the resulting enterprise-value indications.
| Discount rate / WACC | 2% terminal growth | 3% terminal growth | 4% terminal growth |
|---|---|---|---|
| 13% WACC | $4.209M | $4.499M | $4.854M |
| 14.9% WACC | $3.571M | $3.765M | $3.995M |
| 17% WACC | $3.055M | $3.187M | $3.339M |
Enterprise values are US$ millions, rounded to the nearest $1,000. The green cell is the 14.9% WACC / 3% growth base case. On mobile, swipe to read the full matrix.
Lower-risk assumption, 13% WACC
Illustrative operating EV at 3% terminal FCFF growth.
Higher-risk assumption, 17% WACC
Illustrative EV at the same 3% growth rate — a roughly $1.312M difference.
Risk is not just a plug: Investigate customer concentration, financial reporting quality, leadership dependency, debt coverage, capital intensity and forecast execution. Decide which risks belong in expected cash flows and which justify a higher required return. Do not penalize the same risk in both places without explaining why.
Terminal growth must be economically sustainable and consistent with long-run margins, reinvestment, inflation and market opportunities. Gordon-growth terminal value also requires WACC to exceed perpetual growth; the formula becomes unstable as the difference narrows.
Step 06 / Apply the framework
Practice the Cost of Capital Calculations
Try each calculation before opening the answer. The questions deliberately change one assumption at a time to show how the model behaves.
Three Student Practice Questions
Practice 1 — What if the equity risk premium rises to 7.0%?
Keep β = 1.10, the risk-free rate at 4.0%, size premium at 4.0% and CSRP at 3.0%. Revised cost of equity is 4.0% + 1.10 × 7.0% + 4.0% + 3.0% = 18.7%. Revised WACC is 75% × 18.7% + 25% × 9.0% × 75% = 15.7125%, or approximately 15.71%. This is a model sensitivity, not a claim that the ERP is currently 7%.
Practice 2 — What if the hypothetical CSRP falls from 3% to 2%?
The cost of equity falls to 16.6%. With the same assumed capital weights, borrowing cost and tax rate, revised WACC becomes 75% × 16.6% + 25% × 9.0% × 75% = 14.1375%, approximately 14.14%. In real work the change must be supported by risk evidence and cross-checked against forecast assumptions.
Practice 3 — Calculate Year 6 FCFF and the terminal value.
Using the 3.0% perpetual-growth assumption, Year 6 FCFF is $520,000 × 1.03 = $535,600. At 14.9% WACC, terminal value at the end of Year 5 is $535,600 ÷ (14.9% − 3.0%) = approximately $4,500,840. Discount this Year 5 value back five periods to obtain a present value of approximately $2,247,470.
Frequently Asked Questions
1. What discount rate is used to value a private business?
There is no universal rate. The selected rate depends on the relevant cash-flow definition, valuation date, financing, industry, company size, growth, risk, tax assumptions and applicable standard of value. FCFF is commonly discounted at an appropriately developed WACC, while equity cash flow is ordinarily discounted at a cost of equity. All assumptions require support.
2. What is the difference between WACC and cost of equity?
Cost of equity is the return required by equity holders. WACC combines costs of equity and interest-bearing debt, using appropriate capital weights and tax treatment. The two rates are not interchangeable; matching the financing included in the cash flow to the discount rate is fundamental.
3. Can you add a company-specific risk premium to every valuation?
No. A separate CSRP is a judgmental input, not an automatic surcharge. Analysts should identify specific risks, assess what is already captured by peer beta, the size premium, forecasts, or other inputs, and explain why any incremental premium is appropriate and supported. Different methods and practitioners may address those risks differently.
4. How does a discount rate differ from a capitalization rate?
A discount rate applies to a series of projected future cash flows. A direct capitalization rate converts a properly matched representative single-period benefit into a value indication. In a stable-growth, consistently defined FCFF model, a simplified terminal capitalization rate can be approximated by WACC minus perpetual growth, but the earnings/cash-flow measure, timing and growth assumptions must be compatible.
5. Why is terminal value often a large part of a DCF?
A five-year forecast does not include all of a going concern's expected future operating benefits. Terminal value reflects the assumed economics beyond that period. Here approximately 59.7% of modeled enterprise value is attributable to terminal value, so the long-run growth, reinvestment and discount-rate assumptions merit careful testing.
6. Does BVA's valuation course teach WACC, DCF and private-company risk?
Yes. BVA's five-part Private Business Valuation & Deal Analysis Program includes risk-free rates, company-specific risk premiums, long-term growth, private-market risk, free cash flow to the firm, discount rates, intrinsic value, forecasting, DCF, valuation multiples and transaction analysis. The full program includes analytical models and professional reference resources.
Continue your valuation education
Turn a Discount Rate into a Supportable Valuation Analysis
In the full BVA Private Business Valuation & Deal Analysis Program, work through earnings normalization, forecasting, FCFF, risk assessment, DCF, market methods, acquisition financing and investor returns. The free examples introduce the logic; the course develops the repeatable workflow and analytical tools.
Self-paced educational training. Advertised course price and access terms are subject to checkout. Certificates of completion do not confer professional valuation credentials or licenses.
BVA valuation reference library / Free sample lessons
Review the Valuation & Acquisition Foundations
To see the free-cash-flow valuation framework in practice, review the earlier DCF lesson, or revisit acquisition financing before deciding which discount-rate inputs are appropriate.
Further technical reading: CFA Institute — Private Company Valuation | Kroll — Company-Specific Risk Premium. These explain broad concepts; they do not supply the hypothetical numerical inputs used above.
Educational disclosure: Every company characteristic, capitalization assumption, cost-of-capital input, cash-flow forecast, tax rate, discount rate, terminal-growth assumption and valuation figure is fictional and simplified. This is not an independent business appraisal, professional cost-of-capital study, investment forecast, tax opinion, financing recommendation or assurance of market pricing. Real engagements require evidence for normalized forecasts, leverage, capital weights, tax effects, risk premiums, interest expense deductibility, terminal assumptions, standards and ownership rights. No market calibration, control/marketability adjustments, transaction expenses or separate working-capital adjustment are included in this illustration.