What discount rate should be used for Net Operating Losses (NOLs)?

When considering the appropriate discount rate for Net Operating Losses (NOLs), it’s important to understand the nature of NOLs and how they function within the context of valuation and taxation. NOLs can be seen as tax shields or future cash flows, as they can offset taxable income in future periods.

The cost of equity is often selected for discounting NOLs primarily because NOLs reflect the risk inherent in the company's equity, particularly related to how these losses will ultimately impact future taxable income and cash flows available to equity holders. Since NOLs are connected to the firm's ability to generate future profits that will tax these losses, using the cost of equity provides a better reflection of the risk profile that equity investors face.

Furthermore, the duration and uncertainty surrounding the realization of benefits from NOLs—essentially using them against future taxable earnings—mean that the risks and return expectations from an equity perspective are particularly relevant. Equity investors typically demand a higher return compared to debt holders, reflecting the greater risk they undertake, which aligns with the nature of NOLs as uncertain future tax benefits.

The other options would not appropriately capture the risk associated with NOLs. The cost of debt primarily reflects the obligations associated with borrowed