Question

Discounting Cash Flows and Earnings. Under the residual income approach and the discounted cash flow approach to firm valuation, carnings and cash flows, respectively, are discounted using a firm's cost of equity. Discuss why the cost of equity is the appropriate discount rate to use to discount a firm's camings and cash flows. Why is the cost of debt inappropriate to use to discount a firm's earnings or cash flows

Answer 1

Answer:

Cost of debt is used for external source of finance whereas cost of equity is used for internal source of finance.

Explanation:

Debt is the fund borrowed from lender at a standard rate of interest. Equity is fund acquired by the investors and shareholders. The required rate of return for equity is higher than the rate of return to the debt holders. This is because debt holders are safe and they are paid first in case of a bankruptcy and liquidity situation of a company. Debt is considered as cheap source of finance but acquiring higher debt will increase company gearing. It is not suitable to use cost of debt as discount factor for the cash flows of the company. The best and ideal discount factor is WACC which is derived by the combination of debt and equity.