In a DCF, an increase in the discount rate with all else unchanged will:
Correct Answer
D) Lower the present value of the projected cash flows
Why this is correct: A higher discount rate reduces the present value of all future cash flows in a DCF model because each future dollar is worth less today. This effect is compounded over time, impacting all projected cash flows and the reversion. Why the other choices are wrong: "Affect only the final year's cash flow" is wrong because a change in the discount rate affects the present value of every projected cash flow. "Raise the present value of the projected cash flows" is wrong because a higher discount rate decreases, not increases, present value. "Leave present value unchanged but raise the reversion" is wrong because the reversion's present value is also lowered by a higher discount rate; the reversion amount itself is not raised. Exam tip: In DCF, remember the inverse relationship: a higher discount rate always lowers present value, especially for distant cash flows.
Why This Is the Correct Answer
A higher discount rate increases every divisor in the model, reducing each discounted cash flow and therefore the total present value.
Why the Other Options Are Wrong
Option A: Affect only the final year's cash flow
Every year's cash flow is discounted, so all of them are affected, with distant years affected most.
Option B: Raise the present value of the projected cash flows
The relationship is inverse. A higher rate produces a lower present value.
Option C: Leave present value unchanged but raise the reversion
The reversion is itself discounted and is the most rate-sensitive element in the model, not an exception to it.
Higher Rate, Lower Value
Higher Rate, Lower Value — and the far-off reversion loses the most, because the exponent grows with time.
How to use: Run the model at two or three rates. The spread shows how much the conclusion rests on the rate selection.
Exam Tip
Support the discount rate from investor surveys, extracted yields or a build-up. An unsupported rate is the weakest point in most discounted cash flow analyses.
Common Mistakes to Avoid
- -Reversing the rate-value relationship
- -Treating the reversion as unaffected by the rate
- -Selecting a discount rate without market support
Concept Deep Dive
Analysis
A discounted cash flow converts future dollars into present ones by dividing each year's cash flow by one plus the discount rate raised to the power of the year. Raising the rate increases every one of those divisors, so every discounted amount falls and the total present value falls with them. The effect is not uniform: because the exponent grows with time, distant cash flows are reduced far more than near ones, and the reversion at the end of the holding period — usually the largest single figure in the model — is the most sensitive item of all. That sensitivity is why the discount rate must be supported from market evidence rather than selected by feel, and why a sensitivity analysis showing value across a range of rates is often worth presenting. The distractors misstate the relationship in three ways: reversing the direction, confining the effect to one year, and separating the reversion from the discounting that applies to it.
Background Knowledge
Discounted cash flow analysis divides each period's cash flow by one plus the discount rate raised to the period number. Higher rates reduce present value, with the effect growing for more distant cash flows including the reversion.
Real-World Application
An appraiser presents a discounted cash flow at 8, 9 and 10 percent, showing a value spread of nearly 12 percent and explaining the rate selected.
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Next Question
Discounting a projected cash flow stream requires: