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Taxes and tax rates are important to understand when you do DCF valuation. Taxes and tax rates impact your net income, cash flows, capital structure, cost of capital and therefore valuation. Tax rates are applied to operating profits before taxes in your DCF model. But what happens if you do not have any operating profits!?
This page addresses the question: What tax rate would you use if your company currently has operating losses.
Countries operate in multiple countries and every country and state that a company is domiciled in has a tax rates prescribed by law. 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.
This page addresses the question: What tax rate would you use if your cash flows are international and have different tax rates in different jurisdictions?
We do not use the actual tax paid to estimate future tax expense because the actual tax paid will be materially different due to one or more of the following reasons. • The taxes paid accounts for the deductions and deferred tax provisions that apply to a company’s net income. The deferred tax benefits and costs reverse over time. • The taxes paid is lower than effective operating tax liability when a company has debt due to the debt tax shields. This will double count the benefit of tax shields if we also incorporate the tax shield benefits in our discount rate.
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 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. There is no one size fits all tax rate that is best when valuing a company using the DCF valuation approach.
On this page, we address the question: What are the drawbacks of using the statutory tax rate in forecasting cash flows?