Discount rate
DCFThe rate at which future cash flows are reduced to present value, reflecting both the time value of money and risk.
A euro next year is worth less than a euro today, both because it could have been invested and because it might not arrive. The discount rate combines those two into a single number, and dividing by one plus that rate, compounded, converts any future amount into today's money.
The rate must match the cash flows it is applied to. Unlevered free cash flow, which is available to all capital providers, is discounted at WACC. Cash flow to equity is discounted at the cost of equity. Mixing them, most commonly by discounting levered cash flow at WACC, double counts the benefit of debt.
It should also match the currency and the risk of the cash flows. A euro forecast discounted at a dollar cost of capital embeds an implicit currency view that nobody intended, and a stable utility and a speculative biotech cannot share a rate.
Small changes have large consequences on long dated streams, which is why sensitivity tables exist. Two hundred basis points on the discount rate can move a terminal value by a quarter, without anything about the business changing.
Worked example
A cash flow of 100 arriving in year five is worth 68 at an 8% discount rate, and 57 at 12%.
Four points of discount rate removed 17% of the value of that single flow, and the effect compounds the further out the cash sits.
Match the rate to the cash flow: unlevered flows at WACC, equity flows at the cost of equity. Discounting levered cash flow at WACC counts the benefit of debt twice.