Answer 3

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a.     Which one should you choose?

Let's start with what you cannot use - the actual taxes paid. Why not? The actual taxes paid will reflect the fact that you save on taxes when you make interest payments. The problem, however, is that you have already counted the tax benefits in your cost of capital (by using the after-tax cost of debt) and increasing your cashflow for the same reason would be double counting.

It boils down to a choice between effective and marginal tax rates. The effective tax rate is lower than the marginal tax rate for a number of reasons but one reason is that companies defer paying taxes. Since this is a tax saving, there is nothing wrong with using the effective tax rate in computing the after-tax operating income for last year and even for the next few years. If you use it forever, though, you are assuming that you can defer taxes in perpetuity and that is a dangerous assumption. The best compromise is to use effective tax rates for the early forecast years and move towards a marginal tax rate in the later years.

b.     What happens if you are a multinational and are in several countries with very different tax rates?

While some would push for an average tax rate, weighted by the income in each country, I think it makes far more sense to use the marginal tax rate of the country the company is domiciled in as a floor. After all, income earned in countries with lower tax rates than the domestic tax rate eventually has to be repatriated back to the domicile at which point it will be taxed. It is a tougher call for countries with higher marginal tax rates than the domestic tax rate. Here, it does make sense to use a weighted average.

    1. What happens if you are reporting an operating loss?

In the year of the operating loss, the tax rate used in computing the after-tax operating income and the after-tax rate cost of debt should be zero. As you project the earnings into future years and they turn positive, you first have to cover your net operating losses from prior years, during which period your tax rate will still be zero. When you use up your net operating losses, your tax rate will converge on the marginal tax rate.



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