Simplified Discounting Rules, Variable Growth, And Leverage

It was shown earlier that unconditional expected cash flows can be discounted at a constant risk-adjusted discount rate if these cash flows follow a multiplicative binomial process with a constant growth rate (“simplified discounting rule”). This paper extends this analysis to the case of variable growth rates of expected cash flows. The earlier analysis was also based on the assumption of all-equity-financing. The impact of a financing strategy based on deterministic leverage ratios is included in this paper as well. It analyses the conditions to apply the weighted average cost of capital as a discount rate. The paper reflects the results of Modigliani/Miller (1963), Miles/Ezzell (1980), and Löffler (1998) visà-vis the background of this theory and discusses issues of practical application.