There is no one size fits all tax rate that is best when valuing a company using the DCF valuation approach.
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 rate 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.
There is no one size fits all tax rate that is best when valuing a company using the DCF valuation approach.
What are the drawbacks of using an effective tax rate in forecasting cash flows?
We do not use the statutory tax rates in forecasting cash flows due to a few reasons:
- Different statutory tax rates apply based on the level of income or size of the company, type of income, etc.
- Countries operate in multiple countries and every country and state that a company is domiciled in has a tax rates prescribed by law.
- Statutory tax rates do not account for the deductions and deferred tax provisions that apply to a company’s net income.