Final answer:
The correct discount rate for levered firm dividends is the firm's weighted average cost of capital (WACC), which is higher than the cost of debt but lower than the all-equity cost of capital due to the impact of leveraging debt in its capital structure.
Step-by-step explanation:
The right discount rate for the dividends of a levered firm is the firm's weighted average cost of capital (WACC). The WACC accounts for the cost of equity and the cost of debt, weighted by the firm's capital structure. It is used to discount future dividends because it represents the blended return required by the firm's investors, both equity and debt holders.
The WACC is generally higher than the firm's cost of debt alone, as debt is cheaper due to the tax deduction on interest payments and is considered less risky than equity. Conversely, the WACC should be lower than the firm's all-equity cost of capital because debt financing typically has a lower cost. The use of leverage (debt) in a firm's capital structure can lower the WACC up to the point where the firm's risk of financial distress counterbalances the benefits of leverage.
Understanding the relationship between a firm's choice of financing and the associated costs is fundamental. Choosing the proper discount rate plays a critical role in accurately valuing a firm's stock and making investment decisions.