# Discount Rate Calculation

As mentioned in the previous chapter, two types of discount factors - either the cost of equity or the cost of capital (WACC) are used, depending on the type of the discounted valuation model chosen. The cost of equity is typically used with the DDM and to discount free cash-flows to equity whereas WACC must be used to discount the free cash-flows to firm.

## WACC

WACC stands for weighted average cost of capital and as its name says it is a weighted average of its two components, the cost of equity and the cost of debt.

**WACC = Cost of Equity x (Equity/Capital) + After Tax Cost of Debt x (Debt/Capital)**

where:

**Capital = Equity + Debt** and Debt stands for bank debt

## Cost of Debt

The cost of debt used in the WACC calculation is the after tax cost of debt. It is relatively easy to calculate from the actual cost of the company's bank debt and expected interest rate trends and projected changes in the company's financing structure.

## Cost of Equity

The cost of equity is more difficult to estimate as there are no such items in the balance sheet and income statement that could help you calculate it. It is an expected return of investors from investing in equity and it is typically higher than the cost of debt. The most common calculation approach follows the logic of the capital asset pricing model (CAPM) which is used by equity investors to price the risk of investing into securities.

**Cost of Equity = Risk-Free Rate + β x Equity Risk Premium**

where:

**Risk-free rate** is usually estimated as the yield on the long-term (10 years) government paper, such as bonds or T-bills since these investment assets are generally considered to be free from credit risk.

**β (beta)** is a measure of the stock's volatility relative to the equity market's average. Small, young companies in fast growing industries typically have β>1 whereas large, established companies in defensive sectors should have β<1.

**Equity risk premium** is the investor's expected premium over the risk-free rate as a reward for investing in more risky equities. Past market statistics can help you estimate its value.