How to Ensure Consistency between Discount Rates and Cash Flows?

Abstract

There is a lot of confusion among practitioners about valuing firms and investment projects. At the first sight the discounting procedure is a simple and routine task, which does not involve much effort. But actually even in simple cases accurate valuation requires attention to plenty of details. The slightest negligence or insufficient knowledge of underlying theory can result in substantial inaccuracy. Especially, many mistakes occur in the formulation of cost of levered equity and weighted average cost of capital.

The paper examines consistency between cash flows and discount rates. It reveals limitations and implicit assumptions embedded in traditional textbook formulas of CoLE and WACC. Traditional formulations were designed to value perpetuities and relies on constant target market debt-to-equity ratio, the assumption that tax shield on interest expense is earned in full and do not distinguish between payment of interest and repayment of principals. When applied to finite cash flow traditional formulations produce significant distortions. This paper summarizes correct formulations of discount rates for various types of cash flows according to recipients, realization and duration criteria. It also provides a practical example of correct calculations in Excel spreadsheet.

Keywords: Valuation, Cash Flow, WACC, Cost of Equity, Financial Leverage, Cost of Levered Equity, Cost of Unlevered Equity

JEL Classification: M21, M40, M46, M41, G12, G31, J33