What discount rate is used in the UDCF method?

In the UDCF (Unlevered Discounted Cash Flow) method, the appropriate discount rate to use is the Weighted Average Cost of Capital (WACC). This is because WACC reflects the average rate of return that a company is expected to pay to its security holders, adjusted for the proportion of debt and equity in its capital structure.

When calculating UDCF, the aim is to value a company based on its unlevered free cash flows, which are cash flows before interest expenses are accounted for. The WACC is suitable in this context because it incorporates the costs of both equity and debt financing, providing a comprehensive view of the total cost of capital to finance the company's operations. Since the cash flows are unlevered, equity holders and debt holders receive a return on their investment according to their respective contributions to the firm’s capital. Thus, WACC acts as a relevant indicator for discounting the unlevered free cash flows.

Using other discount rates like the cost of equity, adjusted present value (APV), or cost of debt does not accurately represent the overall cost of capital for the firm when calculating unlevered cash flows. The cost of equity alone focuses only on equity financing, while the cost of debt pertains only to the