2nd Step of DCF Valuation

What is financial modelling

Discount Rate:

The rate at which future cash flows and terminal value is discounted is known as Discount Rate. If it is FCFF model then the Discount rate us Cost of Capital (Also known WACC) and if it is FCFE model then the discount rate is Cost of Equity:

Cost of Capital (WACC, Ko): Minimum required rate of return of all investors in the Firm (Includes Debt, common Equity and Preferred Equity)

Formula for WACC calculation:

WACC = Ke*We + Kd*(1-Tax rate)*Wd + KPs*WPs

Where Ke = Cost of equity and We = weight of equity

           Kd = Cost of debt and Wd = weight of debt

KPs = Cost of Preferred equity and WPs = Weight of Preferred equity

Cost of Equity (Ke): Minimum Required rate of return of common equity

Formula: Rf + Beta * (Rm – Rf)

Where Rf represents Risk Free rate

             Rm represents Market Return

            Beta: Beta shows the riskiness of the stock with respect to all market index.

If Beta is 2, then it shows that if market goes up by 10% then individual stock will go up by 20% and market goes down by 10% then individual stock will go down by 20%.

Risk Free Rate:

  1. Take Risk Free Rate of bond of central govt where parent company is listed
  2. Maturity period of bond should be equal to forecast period in DCF

Risk Premium (Rm-Rf): Risk Premium is generally an assumption of analyst. But sometimes, Risk Premium is taken from Historical returnsalso which is not recommended because WACC will be used to discount future cash flows and so we have to think of minimum expected return in future.     

Many times Beta is directly taken from Bloomberg or some other sources, but that beta is historical beta and may be manipulated also and may not reflect the true riskiness of stock and if it is private company then Beta will not be available at all.

So in all these cases, it is suggested to recalculate beta based of Industry average fundamental

Cost of Preferred Stock (KPs): Minimum Required rate of return of preferred equity. Cost of preferred stock is Dividend Rate on Preferred Stock.

Best of luck.

Manoj Kumar

Senior Faculty

Investment Banking Institute

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