Strategic Performance Management and Business Valuation · Fundamentals of Business Valuation

Time Value of Money, WACC and CAPM for Business Valuation

Updated 11 October 2026 · Fact-checked

Valuation converts future cash flows into today's value using a discount rate that reflects risk. Find cost of equity with CAPM, cost of debt after tax, weight them at market values to get WACC, discount FCFF at WACC and FCFE at cost of equity, then add the discounted terminal value.

Understand Time Value of Money, Risk and Discount Rate Basics

A rupee today is worth more than a rupee next year. You can invest it and earn a return, and the future is uncertain. Valuation uses this idea in one move: it brings future cash flows back to today by discounting. The rate you use is the return investors demand for taking that risk.

The discount rate must match the cash flow. Cash flows that belong to all capital providers (debt and equity) are discounted at the WACC, the weighted average of the cost of equity and the after-tax cost of debt. Cash flows that belong only to shareholders are discounted at the cost of equity. Mixing these is the most common valuation error.

Cost of equity is usually found with CAPM: the risk-free rate plus beta times the equity market risk premium. Beta measures how much the share moves with the market. Debt is cheaper than equity because lenders are paid first and interest saves tax, so cost of debt is taken after tax.

Valuation uses cash flow, not accounting profit. FCFF is the cash available to all capital providers after tax on operating profit and after reinvestment in capex and working capital. FCFE is the cash left for shareholders after debt service. Profit includes non-cash items like depreciation and ignores capex, so it can mislead.

A business is assumed to run beyond the forecast years. Terminal value captures all cash flows after the last forecast year, usually with the growing perpetuity formula. It is often more than half of total value, so small changes in growth or discount rate move the answer a lot.

Key rules to remember

Present value: PV = CF ÷ (1 + r)^n; Use PV of annuity or perpetuity formulas for repeating cash flows.
Growing perpetuity: PV = CF₁ ÷ (r − g); Valid only when r > g. CF₁ is the cash flow one year ahead.
CAPM cost of equity: Ke = Rf + β × (Rm − Rf); (Rm − Rf) is the market risk premium. Do not subtract Rf twice.
After-tax cost of debt: Kd (after tax) = Kd × (1 − t); Use the tax rate that applies to the interest deduction.
WACC: WACC = E/(D+E) × Ke + D/(D+E) × Kd × (1 − t); Weights should be at market or target capital structure values.
FCFF: FCFF = EBIT × (1 − t) + Depreciation − Capex − Increase in working capital; Discount at WACC to get enterprise value.
FCFE: FCFE = FCFF − Interest × (1 − t) + Net borrowing; Discount at cost of equity to get equity value directly.
Terminal value (Gordon growth): TV at year n = FCF(n+1) ÷ (r − g) = FCFn × (1 + g) ÷ (r − g); Discount TV back n years at the same rate used for the flows.
Equity value from enterprise value: Equity value = Enterprise value − Debt + Cash and surplus assets; Needed when you use FCFF.

How to solve Time Value of Money, Risk and Discount Rate Basics questions

Use this order for any discount rate or DCF question.

1Identify the cash flow given: FCFF, FCFE or profit. Convert to the right cash flow if needed.
2Choose the matching rate: WACC for FCFF, cost of equity for FCFE.
3Compute cost of equity with CAPM, using Rf, β and the market premium as given.
4Compute after-tax cost of debt, then WACC with the stated weights.
5Discount each forecast cash flow, using the year-end convention unless told otherwise.
6Compute terminal value at the end of the forecast year and discount it with the same factor as that year's flow.
7Add the present values. For FCFF, subtract debt and add cash to reach equity value.
8State the final answer with units and a one-line comment on sensitivity.

Quickest way: Rate-matching shortcut

When to use it: Use in MCQs and when time is short in a DCF question.

Write the rate rule first: FCFF with WACC, FCFE with Ke.
Check whether the market premium or the market return is given before applying CAPM.
Compute Ke and WACC in one line each.
Use cumulative discount factors from the table if supplied.
Check r > g before using the perpetuity formula.
Do a sense check: terminal value should be a plausible multiple of the last cash flow.

Common mistakes in Time Value of Money, Risk and Discount Rate Basics

Discounting FCFF at the cost of equity, or FCFE at WACC.
Students treat any discount rate as interchangeable.
Fix: Match the rate to the claimant: all capital providers get WACC, shareholders get Ke.
Using market return instead of market premium in CAPM.
The question gives Rm and students multiply β by it directly.
Fix: Always compute Rf + β × (Rm − Rf). Read whether the figure is Rm or the premium.
Using pre-tax cost of debt in WACC.
The tax shield step is forgotten when the interest rate is given.
Fix: Multiply by (1 − t) every time unless the question says the rate is already after tax.
Using book values for weights without being asked.
Balance sheet figures are easier to find.
Fix: Use market values or target structure when given. Use book values only when nothing else is available, and say so.
Applying terminal value using the wrong year's cash flow or forgetting to discount it.
Students stop after computing the perpetuity.
Fix: Use cash flow of year n+1 over (r − g), then discount the result by n years.
Reporting enterprise value as the value to shareholders.
The FCFF DCF ends with a single total.
Fix: Subtract debt and add cash to reach equity value, and divide by shares if per-share value is asked.

Worked examples

Example 1

A company has a risk-free rate of 7%, market return of 13% and beta of 1.2. Pre-tax cost of debt is 10% and tax rate is 25%. Market value of equity is ₹60 crore and debt is ₹40 crore. Calculate the WACC.

Show the solution

Market premium = 13% − 7% = 6%.
Ke = 7% + 1.2 × 6% = 14.2%.
After-tax Kd = 10% × (1 − 0.25) = 7.5%.
Total capital = ₹100 crore. Weights: equity 60%, debt 40%.
WACC = 0.60 × 14.2% + 0.40 × 7.5% = 8.52% + 3.00% = 11.52%.

Answer: WACC = 11.52%

Example 2

A firm expects FCFF of ₹10 crore in year 1 and ₹12 crore in year 2. After year 2, FCFF grows at 5% a year forever. WACC is 10%. Debt is ₹50 crore and cash is ₹5 crore. Find the equity value.

Show the solution

Year 3 FCFF = 12 × 1.05 = ₹12.6 crore.
Terminal value at end of year 2 = 12.6 ÷ (0.10 − 0.05) = ₹252 crore.
Discount factors at 10%: year 1 = 0.9091, year 2 = 0.8264.
PV of year 1 = 10 × 0.9091 = ₹9.091 crore.
PV of year 2 = 12 × 0.8264 = ₹9.917 crore.
PV of terminal value = 252 × 0.8264 = ₹208.25 crore.
Enterprise value = 9.091 + 9.917 + 208.253 = ₹227.26 crore (approx.).
Equity value = 227.26 − 50 + 5 = ₹182.26 crore.

Answer: Enterprise value is about ₹227.26 crore and equity value is about ₹182.26 crore.

Exam tips

In MCQs, the trap is usually the rate match or the pre-tax versus after-tax cost of debt. Check both before calculating.
Write the formula and the weights on the page. Marks are given for method even if arithmetic slips.
State assumptions such as year-end cash flows and market-value weights when the question is silent.
For case questions, add a recommendation line on how sensitive value is to the discount rate and growth rate.
Check r > g before using the perpetuity formula. If it fails, say the model is not valid.

Practice questions from Fundamentals of Business Valuation

Time Value of Money, Risk and Discount Rate Basics in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Time Value of Money, Risk and Discount Rate Basics: frequently asked questions

Which discount rate should I use for FCFF and FCFE?

Use WACC for FCFF, because it belongs to both debt and equity holders. Use the cost of equity for FCFE, because it belongs only to shareholders.

How do I calculate cost of equity using CAPM?

Add the risk-free rate to beta multiplied by the market risk premium. The premium is the market return minus the risk-free rate.

Why is cost of debt taken after tax in WACC?

Interest is a tax-deductible expense, so the real cost to the company is lower than the interest rate. Multiply the rate by (1 − tax rate).

How do I calculate terminal value?

For a stable growth business, divide the next year's cash flow by (discount rate − growth rate). This gives value at the end of the forecast period, which you must then discount to today.