**More on effective tax
rates**

To
compute the after-tax operating income, you multiply the earnings before
interest and taxes by an estimated tax rate. This simple procedure can be
complicated by three issues that often arise in valuation. The first is the
wide differences you observe between effective and marginal tax rates for these
firms and the choice you face between the two in valuation. The second issue
arises usually with younger firms and is caused by the large losses they often
report, leading to large net operating losses that are carried forward and can
save taxes in future years. The third issue arises from the capitalizing of
research and development and other expenses. The fact that these expenditures
can be expensed immediately leads to much higher tax benefits for the firm.

You are faced with a choice of several
different tax rates. The most widely reported tax rate in financial statements
is the *effective tax rate*,
which is computed from the reported income statement.

Effective Tax Rate =

The
second choice on tax rates is the *marginal tax rat*e, which is the tax rate the firm faces
on its last dollar of income. This rate depends on the tax code and reflects
what firms have to pay as taxes on their marginal income. In the United States,
for instance, the federal corporate tax rate on marginal income is 35%; with
the addition of state and local taxes, most firms face a marginal corporate tax
rate of 40% or higher.

While
the marginal tax rates for most firms in the United States should be fairly
similar, there are wide differences in effective tax rates across firms. Figure
10.1 provides a distribution of effective tax rates for firms in the United
States in January 2001.

Note
that the number of firms reporting effective tax rates of less than 10% as well
as the number of firms reporting effective tax rates of more than 100%. In
addition, it is worth noting that this table does not include about 2000 firms
that did not pay taxes during the most recent financial year or have a negative
effective tax rate.[1]

Given that most of the taxable income of
publicly traded firms is at the highest marginal tax bracket, why would a
firmÕs effective tax rate be different from its marginal tax rate? There are at
least three reasons:

1.
Many firms,
at least in the United States, follow different accounting standards for tax
and reporting purposes. For instance, firms often use straight line
depreciation for reporting purposes and accelerated depreciation for tax purposes.
As a consequence, the reported income is significantly higher than the taxable
income, on which taxes are based[2].

2.
Firms
sometimes use tax credits to reduce the taxes they pay. These credits, in turn,
can reduce the effective tax rate below the marginal tax rate.

3.
Finally,
firms can sometimes defer taxes on income to future periods. If firms defer
taxes, the taxes paid in the current period will be at a rate lower than the
marginal tax rate. In a later period, however, when the firm pays the deferred
taxes, the effective tax rate will be higher than the marginal tax rate.

4.
The
structure of the tax rates is tiered with the first $X in income taxed at a
lower rate (15%), the subsequent $Y in income taxed at a higher rate (?%) and
any amount over $Z taxed at 35%.
As a result, the effective tax rate based on the total tax a firm pays
will be lower than the marginal tax rate which is 35%.

When
a firm has global operations, its income is taxed at different rates in different
locales. When this occurs, what is the marginal tax rate for the firm? There
are three ways in which we can deal with different tax rates.

- The first
is to use a weighted average of the marginal tax rates, with the weights
based upon the income derived by the firm from each of these countries.
The problem with this approach is that the weights will change over time
if income is growing at different rates in different countries.
- The
second is to use the marginal tax rate of the country in which the company
is incorporated, with the implicit assumption being that the income
generated in other countries will eventually have to be repatriated to the
country of origin, at which point the firm will have to pay the marginal
tax rate. This assumes that the home country has the highest marginal tax
rate of all other countries.
- The third
and safest approach is to keep the income from each country separate and
apply a different marginal tax rate to each income stream.

In valuing a firm, should you use the
marginal or the effective tax rates? If the same tax rate has to be applied to
earnings every period, the safer choice is the marginal tax rate because none
of the reasons noted above can be sustained in perpetuity. As new capital expenditures
taper off, the difference between reported and tax income will narrow; tax
credits are seldom perpetual; and firms eventually do have to pay their
deferred taxes. There is no reason, however, why the tax rates used to compute
the after-tax cash flows cannot change over time. Thus, in valuing a firm with
an effective tax rate of 24% in the current period and
a marginal tax rate of 35%, you can estimate the first yearÕs cash flows using
the effective tax rate of 24% and then increase the tax rate to 35% over time.
It is critical that the tax rate used in perpetuity to compute the terminal
value be the marginal tax rate.

When
valuing equity, we often start with net income or earnings per share, which are
after-tax earnings. While it looks like we can avoid dealing with the
estimating of tax rates when using after-tax earnings, appearances are
deceptive. The current after-tax earnings of a firm reflect the taxes paid this
year. To the extent that tax planning or deferral caused this payment to be
very low (low effective tax rates) or very high (high effective tax rates), we
run the risk of assuming that the firm can continue to do this in the future if
we do not adjust the net income for changes in the tax rates in future years.

For
firms with large net operating losses carried forward or continuing operating
losses, there is the potential for significant tax savings in the first few
years that they generate positive earnings. There are two ways of capturing
this effect.

One is to change tax rates over time. In
the early years, these firms will have a zero tax rate as losses carried
forward offset income. As the net operating losses decrease, the tax rates will
climb toward the marginal tax rate. As the tax rates used to estimate the
after-tax operating income change, the rates used to compute the after-tax cost
of debt in the cost of capital computation also need to change. Thus, for a
firm with net operating losses carried forward, the tax rate used for both the
computation of after-tax operating income and cost of capital will be zero
during the years when the losses shelter income.

The other approach is often used when
valuing firms that already have positive earnings but have a large net
operating loss carried forward. Analysts will often value the firm, ignoring
the tax savings generated by net operating losses, and then add to this amount
the expected tax savings from net operating losses. Often, the expected tax
savings are estimated by multiplying the tax rate by the net operating loss.
The limitation of doing this is that it assumes that the tax savings are both
guaranteed and instantaneous. To the extent that firms have to generate
earnings to create these tax savings and there is uncertainty about earnings,
it will over estimate the value of the tax savings.

There are two final points that needs to be made about operating losses. To the extent that a potential acquirer can claim the tax savings from net operating losses sooner than the firm generating these losses, there can be potential for tax synergy that we will examine in the chapter on acquisitions. The other is that there are countries where there are significant limitations in how far forward or back operating losses can be applied. If this is the case, the value of these net operating losses may be curtailed.

[1] A negative effective tax rate usually arises because a firm is reporting an income in its tax books (on which it pays taxes) and a loss in its reporting books.

[2] Since the effective tax rate is based upon the taxes paid (which comes from the tax statement), the effective tax rate will be lower than the marginal tax rate for firms that change accounting methods to inflate reported earnings.