Series 79 practice questioneasyDCF Analysis
In a discounted cash flow (DCF) analysis, which of the following best describes the purpose of the discount rate?
- ATo account for inflation in future cash flows
- BPresent-value discounting for time and risk✓ Correct answer
- CTo calculate the company's tax shield from debt financing
- DTo determine the company's dividend payout ratio
Explanation
Why B — Present-value discounting for time and risk
The discount rate in a DCF analysis converts future cash flows to their present value by reflecting both the time value of money and the riskiness of those cash flows. Investors require a return for deferring consumption and bearing risk, so a dollar received in the future is worth less than a dollar today. The appropriate discount rate for an unlevered DCF is typically the weighted average cost of capital (WACC).
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