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.
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.
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.
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.
