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Which tax rate should you choose in preparing a DCF cash flow?

Multiple tax rates apply to a company. Federal /state statutory tax rates, Effective tax rates, marginal tax rates, etc.

Federal /State Statutory Tax Rate: Every country and state that a company is domiciled in has a tax rates prescribed by law. In most countries, different tax rates apply based on the level of income or size of the company, type of income, etc.

Effective Tax Rate: Effective tax rate is the tax expense divided by the pretax income of a specific year. The taxes expense of a company is arrived at according to the statutory tax rates and tax slabs applicable to the company. If the company earns income from multiple countries, multiple statutory tax rates and tax slabs will apply to different portions of income according to local laws and intercountry tax agreements such as double tax avoidance agreements.

Marginal Tax Rate: The marginal tax rate is the tax rate applicable to the last dollar (marginal income). This marginal tax rate is usually the tax rate applicable to the highest slab that applies to the tax-payer.

This article looks at which tax rate you choose in preparing a DCF cash flow.

Do you apply the midyear convention to a stub period? If yes, how?

Yes, you can apply the midyear convention to a stub period. The period between the valuation date/transaction date and the beginning of the financial year is considered a stub period. It is usually a fraction of a year or quarter as valuations can be done throughout the year and not just at the end of a period.

Take the period between the valuation date/transaction date and the beginning of the financial year as a fraction of the time period and divide it by two. Then, use that number as the time period to discount with.

What is a stub period? When does the stub period arise when valuing a company using the DCF method?

The period between the valuation date/transaction date and the beginning of the financial year is called a stub period. It is usually a fraction of a year or quarter. The stub period arises because valuations can be done throughout the year and not just at the end of a period.

A stub period can also arise if the valuation date and data of completion of the transaction are different.

Does the midyear convention have a larger impact on the value of the business when the discount rate is higher or lower?

The present value concept discounts the cash flows of a period by the entire period using the discount rate. The DCF valuation method relies on the present value concept to value the cash flows of a business. Therefore the DCF valuation method also discounts the cash flows of a period by the entire period using the discount rate. However, this may not be an appropriate reflection of reality. Thus enters the midyear convention.

The midyear convention is the assumption that cash flows occur in the middle of the year.

Most DCF models assume that cash flows occur at the end of the year. This assumption causes the entire cash flows for the year to be discounted by a full year. A business whose cash flows occurs evenly during the year is penalized when you discount all its cash flows for an entire year. The midyear convention takes the midpoint of the year as the point in time that the year’s cash is received. The midyear convention discounts the first half of the period more than it should and the second half of the period less than it should – thereby averaging it out evenly. The midyear convention makes the midyear convention closer to reality and a better assumption for most companies.

What DCF assumptions have the most weight on your decision to use a midyear convention?

The present value concept discounts the cash flows of a period by the entire period using the discount rate. The DCF valuation method relies on the present value concept to value the cash flows of a business. Therefore the DCF valuation method also discounts the cash flows of a period by the entire period using the discount rate. However, this may not be an appropriate reflection of reality. Thus enters the midyear convention.

And thus enters the mid year convention! The midyear convention is the assumption that cash flows occur in the middle of the year.

In this article, we address what factors have the most weight on your decision to use a midyear convention?

How does midyear convention impact terminal value calculation?

The present value concept discounts the cash flows of a period by the entire period using the discount rate. The DCF valuation method relies on the present value concept to value the cash flows of a business. Therefore the DCF valuation method also discounts the cash flows of a period by the entire period using the discount rate. However, this may not be an appropriate reflection of reality. Thus enters the midyear convention.

What is the midyear convention? When and why do we use the midyear convention?

The present value concept discounts the cash flows of a period by the entire period using the discount rate. The DCF valuation method relies on the present value concept to value the cash flows of a business. Therefore the DCF valuation method also discounts the cash flows of a period by the entire period using the discount rate. However, this may not be an appropriate reflection of reality.

And thus enters the mid year convention!

Do you account for business cycles when preparing a cash flow forecast? If yes, how?

Business cycles are part and parcel of life in certain industries. An excellent example of industries that have cycles is commodities. Another example is the shipping industry. Are these business cycles considered abnormal events? Are they required to be normalized? If they are to be normalized, how do you normalize them?

Why is normalization done?

Normalization of earnings is done for prior years to understand the cash flows generated by the core business in a normal year. Every year brings surprises. If these surprises are random one-off events that are not likely to occur, it is considered abnormal and removed to reflect what the earnings may have been in a normal year. Normalization is done to help you estimate future operating cash flows to use in a DCF valuation.

What are normalized earnings?

Earnings that reflect a typical year is considered “normalized” earnings.  Every year brings surprises. If these surprises are random one-off events that are not likely to occur, it is considered abnormal and removed to reflect the earnings in a normal year.

Events considered abnormal and removed to normalize earnings may be positive (income) or negative (expenses) events.

Examples of events that need normalization:. Examples of expenses that are adjusted in normalizing earnings include litigation fees, unusual discretionary expenses, one of penalties and fines. Examples of income that are adjusted in normalizing earnings include awards received, unusual and one of projects, etc.

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