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WACC / Discount Rate Assumption Checklist

Checklist • Intermediate • 3 min read

Audience
Model Developers • Auditors
Last Reviewed
July 2026
Updated
Version 1.0

Executive Summary

The discount rate is one of the two assumptions, alongside terminal value, with the largest single effect on a DCF's conclusion, and it is built from several individually judgement-dependent components. This checklist isolates the discount rate build for focused review — the cost of equity build (risk-free rate, beta, equity risk premium, and any size or country premia), the cost of debt build, capital structure weights, circularity handling between WACC and enterprise value, and the sourcing documentation for every input — for a model builder, reviewer, or auditor to work through before relying on the rate.

Key Takeaways

  • ✓ The discount rate is built from several individually judgement-dependent components, each of which should be reviewed and sourced separately rather than accepted as a single blended figure.
  • ✓ Beta source and the unlevering/relevering process behind it are frequently under-documented relative to their effect on the cost of equity.
  • ✓ Capital structure weights should reflect market or target values, not book values, and should be consistent with the debt schedule modelled elsewhere.
  • ✓ Any circularity between WACC, enterprise value, and capital structure weights must be explicitly handled, either eliminated with fixed target weights or controlled with documented convergence settings.

Purpose

This checklist isolates the discount rate build for focused review, given its outsized and compounding effect on every year of a DCF's forecast. It complements the broader DCF Model Review Checklist and should be worked through specifically for any DCF where the discount rate has not already been independently reviewed line by line.

1. Cost of Equity Build

  • [ ] The risk-free rate is sourced from a long-dated government bond yield appropriate to the valuation's currency and geography, with the source and date disclosed
  • [ ] The beta used is disclosed as either directly observed (for a listed company) or derived from a comparable company set, with the unlevering and relevering methodology shown where derived
  • [ ] The equity risk premium is sourced and dated, with its basis (e.g., historical or implied) disclosed
  • [ ] Any country risk premium applied is justified by the specific geography of the cash flows being valued, not applied by default
  • [ ] Any size premium applied is justified by the specific size and liquidity characteristics of the subject company, with its source disclosed
  • [ ] The resulting cost of equity is calculated via a disclosed, auditable formula (typically CAPM), not entered as a standalone hardcoded figure

2. Cost of Debt Build

  • [ ] The pre-tax cost of debt is sourced from either the company's actual marginal borrowing rate or a defensible proxy (e.g., synthetic rating-based yield), with the basis disclosed
  • [ ] The choice between marginal and embedded (historical average) cost of debt is stated explicitly and is appropriate to the valuation's purpose
  • [ ] The tax rate used to calculate the after-tax cost of debt matches the tax rate used elsewhere in the free cash flow build

3. Capital Structure Weights

  • [ ] Capital structure weights are based on market values or a stated target structure, not book values
  • [ ] The weights are consistent with the capital structure modelled in the debt schedule and balance sheet elsewhere in the model
  • [ ] Where a target structure is used instead of the current structure, the rationale for the target is documented

4. Circularity Handling

  • [ ] Any circular reference between WACC, enterprise value, and market-value capital structure weights has been identified
  • [ ] The circularity is either eliminated by using a fixed target capital structure, or controlled with documented iterative convergence settings
  • [ ] If iterative calculation is used, the convergence tolerance and iteration limit are documented, and the workbook's iterative calculation setting is disclosed to any reviewer opening the file

5. Documentation and Sourcing

  • [ ] Every WACC input — risk-free rate, beta, equity risk premium, country premium, size premium, cost of debt, tax rate, capital structure weights — is traceable to a single, labelled, sourced assumption cell
  • [ ] No WACC input is hardcoded directly inside the WACC formula itself
  • [ ] The source and as-of date for every market-derived input (risk-free rate, ERP, beta, cost of debt) is recorded alongside the assumption, not left to institutional memory

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Prerequisites

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Frequently Asked Questions

Why does the discount rate deserve its own checklist separate from the general DCF review checklist?

Because the discount rate is built from several individually judgement-dependent components — risk-free rate, beta, equity risk premium, cost of debt, capital structure weights — each of which carries its own sourcing and reasonableness questions, and errors in any one of them compound into the single rate applied to every year of the forecast.

What is the most commonly under-documented input in a WACC build?

Beta. Its source — whether observed directly for a listed company or derived from a set of comparable companies with an unlevering and relevering adjustment — is frequently left undocumented, even though the choice of comparable set and the unlevering methodology can materially change the resulting cost of equity.

Should capital structure weights be based on book or market values?

Market or target values, not book values. Book value capital structure weights do not reflect the actual financing mix the discount rate is meant to represent, and using them is a common source of an understated or overstated WACC.

What is WACC circularity and why does this checklist address it?

WACC circularity arises because WACC depends on capital structure weights based on market value of equity, which itself depends on the DCF output being calculated using WACC — a circular reference. This checklist requires that circularity be explicitly handled, either eliminated using a fixed target structure or controlled with documented convergence settings, addressed further in the WACC Circularity guide.

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Discounted Cash Flow (DCF) Valuation

Discounted cash flow (DCF) valuation values a business, project, or asset as the present value of the cash flows it is expected to generate in the future. It is the most theoretically grounded of the major valuation methodologies, resting directly on the principle that a dollar of cash flow is worth more today than the same dollar received in the future, and that value is created when future cash flows exceed what capital providers require as compensation for the time value of money and risk. This page is the hub for the Knowledge Centre's DCF content: what DCF is and why it works, how free cash flow and discount rates are built, how terminal value is calculated and stress-tested, the method variants practitioners choose between, and — distinctively — how DCF failure modes map onto FMAE's existing structural audit rule taxonomy, since no generic valuation resource ties DCF mechanics to a named, testable audit standard.

WACC (Weighted Average Cost of Capital)

WACC (Weighted Average Cost of Capital) is the rate of return that a company must earn on its existing assets to maintain the value of its equity and satisfy both its debt holders and equity investors. It is calculated as the weighted average of the after-tax cost of debt and the cost of equity, with the weights determined by the proportion of each in the total capital structure. WACC is used primarily as the discount rate in a discounted cash flow (DCF) valuation, where it converts projected free cash flows into present value. It is also used as a return hurdle: a project or investment is value-creating if its expected return exceeds the WACC.

How to Build WACC (Step-by-Step)

Building WACC correctly requires three separate sub-builds — cost of equity via CAPM, after-tax cost of debt, and capital structure weights — combined into a single weighted average. Each sub-build has its own inputs, sources, and common errors, and the overall WACC figure is only as reliable as the weakest of its components. This guide walks through each step in order, the capital structure weighting convention (market values, not book values), and the structural checks that confirm the build is internally consistent with the rest of the model, including the circularity that arises when capital structure weights depend on a total value that itself depends on WACC.

Resolving WACC Circularity in a DCF Model

A circular reference arises in a DCF model whenever WACC's capital structure weights are drawn from the model's own calculated enterprise value, since that value is itself the output of discounting cash flow at WACC. This guide sets out why the circularity occurs, the two standard resolution approaches — using a fixed target capital structure to eliminate the circularity entirely, or a controlled iterative calculation with documented convergence settings where target weights are not appropriate — and the structural audit checks that confirm whichever approach is used has been implemented correctly and consistently.
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