LOS i: Explain the appropriateness of using a particular rate of return as a discount rate, given a description of the cash flow to be discounted and other relevant facts.

Q1. To determine which rate of return to use as a discount rate, an analyst should consider the:

A)   nature of the cash flows being discounted.

B)   length of the holding period.

C)   likely return of the stock market over the next year.

Q2. Cash flows to the firm should be discounted at the:

A)   market’s estimated rate of return.

B)   firm’s weighted average cost of capital.

C)   rate determined by the capital asset pricing model.

Q3. Joe Bates, CFA, has prepared a schedule of real cash flows for his company’s plant expansion. Bates generally uses the weighted average cost of capital to discount such cash flows, but in order to accurately determine the present value of those real cash flows, he should adjust the discount rate to reflect:

A)   the company’s cost of both debt and equity.

B)   expected changes in the market growth rate.

C)   expected inflation.

LOS i: Explain the appropriateness of using a particular rate of return as a discount rate, given a description of the cash flow to be discounted and other relevant facts. fficeffice" />

Q1. To determine which rate of return to use as a discount rate, an analyst should consider the:

A)   nature of the cash flows being discounted.

B)   length of the holding period.

C)   likely return of the stock market over the next year.

Correct answer is A)

The discount rate should correspond to the type of cash flow being discounted. The holding period determines how we calculate the present value, but not the discount rate. Expected stock-market returns are a suitable discount rate for some investments, but not all.

Q2. Cash flows to the firm should be discounted at the:

A)   market’s estimated rate of return.

B)   firm’s weighted average cost of capital.

C)   rate determined by the capital asset pricing model.

Correct answer is B)

The weighted average cost of capital is the preferred discount rate for cash flows to the firm, as it reflects the cost of both debt and equity.

Q3. Joe Bates, CFA, has prepared a schedule of real cash flows for his company’s plant expansion. Bates generally uses the weighted average cost of capital to discount such cash flows, but in order to accurately determine the present value of those real cash flows, he should adjust the discount rate to reflect:

A)   the company’s cost of both debt and equity.

B)   expected changes in the market growth rate.

C)   expected inflation.

Correct answer is C)

In the context of cash flows, “real” refers to inflation-adjusted cash flows. The weighted average cost of capital already takes the cost of both debt and equity into account, but this is a nominal, not a real, discount rate. The market’s growth rate is rarely relevant to cash flows to the firm and is not part of the WACC calculation.