What is the role of WACC in a Discounted Cash Flow analysis?

In a Discounted Cash Flow (DCF) analysis, the Weighted Average Cost of Capital (WACC) serves as the discount rate that is applied to forecasted cash flows in order to bring those future cash flows to their present value. This is a crucial step in the DCF process, as it allows analysts to assess the value of an investment based on its expected future performance and the cost of financing that performance.

WACC reflects the average rate of return that a company is expected to pay to its equity and debt holders, weighted by the proportion of each in the firm’s capital structure. By using WACC, analysts are able to account for the risk associated with the investment, as it incorporates both equity and debt costs. Therefore, using WACC as the discount rate provides a realistic view of the present value of future cash flows and helps investors determine if an investment aligns with their required return thresholds.

This role is distinct from calculating terminal value, determining market capitalization, or identifying investment risks, as those relate to different aspects of valuation and financial analysis.