How can we know which rate to use(Risk free or cost of capital) to discount cash flows?
Thanks
If your cash flows are already adjusted for risk (they are lower than normal cash flows) you use risk-free rate for discount. However, is difficult to adjust cash flows for risk.
If your cash flows already include the risk of the project (which are the most common cash flows displayed everywhere) you use WACC. This method is easier because you adjust the rate for risk only.
On the exam, they’ll let you know which rate to use. Not directly – they won’t say, “Discount at _ this _ rate.” – but obliquely: they’ll tell you that the project has no risk (use the risk-free rate), or that the project’s risk is average for this company (use WACC), or that the project’s risk is unusual for this company (use WACC plus a spread given in the problem).