The discount rate is the rate at which the value of money declines. This loss of value over time is a central concept in finance and is captured by the term ‘time value of money’.

The discount rate is the cost of capital when valuing assets. There are various types and sources of capital. On one extreme, we have debt which provides a fixed rate of interest but no ownership. And on the other extreme, we have equity which does not promise a fixed rate of return but provides ownership in the firm. In between these two extremes, there are several hybrid types of capital that combine some combination of ownership and promised return (convertible debt, preferred shares, etc.). We assume that the firm is funded by debt and equity only to keep things simple in this model. 

The cost of debt is the cost of borrowing money or the interest cost. The cost of equity is not specified in the equity contract and we will learn to estimate it later in this chapter. Since a firm uses both debt and equity capital, we must use the cost of debt and cost of equity to arrive at the total cost of capital. The quantity used and the cost of the two types of capital will be different. Therefore, we weigh the cost of capital in the proportion of debt and equity used by the company to arrive at the weighted average cost of capital. This weighted average cost of capital is the discount rate we refer to as the WACC.