Discount Rates: WACC, CAPM, and Build-Up Without the Headache

Why Discount Rates Matter So Much

In a DCF, the discount rate can swing value by 50% or more. A rate that's too low inflates value; too high destroys it. Understanding how rates work is essential.

The Basic Concept

A dollar today is worth more than a dollar tomorrow because:

1. Time value of money: You could invest today's dollar
2. Risk: Tomorrow's dollar might not arrive
3. Inflation: Tomorrow's dollar buys less

The discount rate captures all three factors.

WACC: Weighted Average Cost of Capital

For established companies, WACC blends the cost of equity and cost of debt, weighted by capital structure.

Formula:
WACC = (E/V × Re) + (D/V × Rd × (1-T))

Where:

• E = Equity value, D = Debt value, V = Total value
• Re = Cost of equity, Rd = Cost of debt
• T = Tax rate

CAPM: Capital Asset Pricing Model

The most common way to estimate cost of equity:

Formula:
Re = Rf + β × (Rm - Rf)

Where:

• Rf = Risk-free rate (Treasury yields)
• β = Beta (volatility relative to market)
• Rm - Rf = Market risk premium

Beta Considerations

• Public company beta from stock data
• Private company? Use comparable public companies
• Unlever and relever for capital structure differences

Build-Up Method

For private companies, especially smaller ones, build-up adds premiums to base rates:

Components:

• Risk-free rate: ~4-5%
• Equity risk premium: ~5-7%
• Size premium: 2-6% (smaller = higher)
• Industry risk: Variable
• Company-specific risk: 0-10%+

Total: Often 15-30% for private companies

What Rate Should You Use?

Large public company: 8-12% (WACC-based)
Mid-size private company: 12-18% (Build-up)
Early-stage startup: 25-50%+ (Very high risk)

Common Mistakes

Using Public Company Rates for Private Companies

Private companies are less liquid and diversified. They need higher rates.

Ignoring Size Premium

Small companies fail more often. The data clearly shows size premiums exist.

Double-Counting Risk

If you've already risk-adjusted cash flows, don't also inflate the discount rate.

Next Steps

Need help determining the right discount rate for your valuation? Book a call to discuss your specific situation.