What is the significance of weighted average cost of capital (WACC) in DCF?

Weighted average cost of capital (WACC) plays a crucial role in discounted cash flow (DCF) analysis because it serves as the discount rate. DCF relies on projecting future cash flows and then discounting them back to their present value to assess a company's value. WACC reflects the average rate that a company is expected to pay to finance its assets, incorporating the costs of equity and debt based on their respective proportions in the company’s capital structure.

When using WACC as the discount rate, it means that the projected cash flows are being evaluated based on the required rate of return from investors, thereby ensuring that the valuation accurately represents the risks and returns associated with the investment. A higher WACC indicates higher perceived risk or costs associated with financing, which would lower the present value of future cash flows. Conversely, a lower WACC suggests lower risk or costs, resulting in a higher present value.

Utilizing WACC as the discount rate in DCF is essential for obtaining a realistic estimate of a company's valuation, as it captures both the cost of equity and the cost of debt, weighted according to their proportions. This significance underlines why this option is considered correct in the context of the question.