In a levered DCF, what discount rate is applied?

In a levered discounted cash flow (DCF) analysis, the appropriate discount rate to apply is the cost of equity. This is because levered DCF focuses on cash flows that are available to equity holders after accounting for interest expenses. The cost of equity reflects the return rate that equity investors expect from their investment in a company, considering the risk associated with that investment.

When performing a levered DCF, you are typically using free cash flows to equity (FCFE), which are calculated after all debt obligations have been met. Hence, the cash flows used in this analysis are only relevant to equity investors, necessitating the use of the cost of equity as the discount rate.

In contrast, the weighted average cost of capital (WACC) is used in unlevered DCF analysis. WACC incorporates both equity and debt costs and accounts for the firm as a whole, not just equity holders. The cost of debt is generally relevant for assessing the firm's overall financing cost but does not directly apply to cash flows designated for equity holders in a levered analysis. The risk premium is related to the return over a risk-free rate but is not used as a standalone discount rate in DCF computations.