Discount rate mismatch
DCFDiscounting a cash flow at a rate belonging to a different set of claimants, the commonest structural error in a candidate built DCF.
Also written: mismatched discount rate, cash flow and discount rate mismatch
The rule the mismatch breaks is simple to state. The numerator names its claimants and the denominator has to name the same ones. Unlevered cash flow is available to lenders and shareholders together, so it takes WACC. Levered cash flow is what remains after the lenders are paid, so it takes the cost of equity.
Cross them one way, unlevered flow at the cost of equity, and the entire cash flow is charged at the price of equity risk even though lenders are funding part of the business at a lower rate. The value comes out too low.
Cross them the other way, levered flow at WACC, and the cost of debt is charged twice: once as interest already deducted inside the cash flow, and once through the debt weighting inside WACC. If net debt is then subtracted out of habit, the lenders are charged a third time and the equity value ends up well below the truth.
Two related mismatches follow the same logic and are worth checking in the same pass. Nominal cash flows take a nominal rate and real cash flows take a real rate. And a forecast in one currency takes a discount rate in that currency, or the flows get converted before a different rate is applied, never a mixture. In every case the error is invisible in the output, which is why the check has to be structural rather than a matter of noticing that the answer looks odd.
Worked example
Illustrative perpetuity: 100 of unlevered free cash flow, 400 of net debt at 5% pre tax, 25% tax, WACC 8%, cost of equity 10%. The correct equity value is 1,250 less 400, so 850.
Unlevered flow at the cost of equity: 100 divided by 10% is 1,000, less 400, so 600. That is 250 too low.
Levered flow of 85 at WACC: 85 divided by 8% is 1,063, and subtracting 400 gives 663. That is 187 too low. Neither error changes anything on the face of the model.