Since the free cash flows in an unlevered DCF analysis are pre-debt (i.e. a helpful way to think about this is to think of unlevered cash flows as the company’s cash flows as if it had no debt – so no interest expense, and no tax benefit from that interest expense), the cost of the cash flows relate to both the lenders and the equity providers of capital. Thus, the discount rate is the weighted average cost of capital to all providers of capital (both debt and equity).
The cost of debt is readily observable in the market as the yield on debt with equivalent risk, while the cost of equity is more difficult to estimate.
Cost of equity is typically estimated using the capital asset pricing model (CAPM), which links the expected return of equity to its sensitivity to the overall market (see WSP’s DCF module for a detailed analysis of calculating the cost of equity).
