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Lecture 10

FINA 410 Lecture 10: Chapter 10 – From Earnings to Cash Flows

Course Code
FINA 410
Jean Mayer

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Chapter 10 From Earnings to Cash Flows
Why cash flows? Because the value of an asset comes from its capacity to generate cash
When valuing firm: cash flows should be after taxes & reinvestment but before debt
When valuing equity: cash flows should be after debt payments
3 basic steps to estimating cash flows:
1. Estimate the earnings generated by a firm on its existing assets and investments
(previous chapter)
2. Estimate the portion of this income that would go towards paying taxes
3. Develop a measure of how much a firm is reinvesting back for future growth
Chaper focus is on last two steps:
o Start with investigating the difference between effective & marginal taxes, as well as
the effects of net operating losses carried forward
o To know how much a firm is reinvesting, we will break it down into:
(Net Capital expenditures): tangible and long-lived assets
(Working Capital): short term assets
Reinvestment will include investement in R&D and acquisitions as part of
The Tax Effect
After-tax operating income= EBIT * tax rate
This is complicated by 3 issues:
1. The wide differences you observe between effective and marginal tax rates for these
firms: which to choose?
Effective Tax Rate = _ Taxes Due .
Taxable Income
2. Firms with large losses: leading to net operating losses that are carried forward and can
save taxes in future years
3. The capitalizing of R&D and other expenses: because these expenditures can be
expensed immediately they have much higher tax benefits for the firm
Effective Versus Marginal Tax Rate
Choice between the two tax rates:
Choice 1: Effective tax is the most widely reported tax rate, computed from the income
statement as follows:
Effective tax rate = Taxes Due .
Taxable Income
Choice 2: Marginal tax rate is the tax rate the firm faces on its last dollar of income
o Reflects what firms have to pay as taxes on their marginal income
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o Ex. U.S federal tax rate on marginal income is 35% with additional state taxes a
corporate firm can have over 40% tax rate
Reasons for Differences Between Marginal and Effective Tax Rates
Given that most firms are at the top tax bracket, why is the effective rate so low? (why are
they different?)
1. Many firms follow different accounting standards for tax and for reporting purposes
o Firms use straight line depreciation for reporting purposes
o Accelerated depreciation for tax purposes
o Thus, the reported income is significantly higher than the taxable income, on which
taxes are based
2. Firms sometimes use tax credits to reduce the taxes they pay
o These credits can reduce the effective tax rate below the marginal tax rate
3. Firms can sometimes defer taxes on income to future periods
o If deferred: taxes paid in current period less so effective tax rate will be at a lower
rate than the marginal tax rate
o Later, when firm pays deferred taxes effective tax rate will be higher than the
marginal tax rate
4. Firm that generate substantial foreign income with lower tax rates do not have to pay
domestic taxes until that income is repatriated back home
Marginal Tax Rates for Multinationals
When a firm has global operations, its income is taxed at different rates in different locales
3 ways to deal with different tax rates:
1. Use a weighted average of the marginal tax rates of each country weights based on
income from each country
o Problem: the weights will change over time, if income is growing at different rates in
different countries
2. Use the marginal tax rate of the country in which the company is incorporated, because:
o Income generated in other countries will eventually have to be repatriated to the
country of origin
3. Keep the income from each country separate and apply a different marginal tax rate to
each income stream
Effects of Tax Rate on Value
CHOOSE MARGINAL TAX RATE if the same tax rates has to be applied to earnings
every period
The safer choice is the marginal tax rate because:
o None of the four reasons noted can be sustained in perpetuity
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o As new capital expenditures taper off, the difference between reported and tax income
will narrow
o Firms eventually do have to pay their deferred taxes
No one is obliging you to keep the same tax rate over time, for example, if your
effective tax rate is 24% now but you marginal tax rate (the one we should use is
35%) you can use the 24% as your marginal tax rate this period and increase it
until it reaches the 35% in future periods.
GOOD PRACTICE: the tax rate you end up using in perpetuity to compute the
terminal value should be the marginal tax rate.
o One can start from the effective tax rate and progressively increase it towards the
marginal rate
Note: when we value equity we usually use after-tax earning (net income) this
does not avoid the problem of estimating tax rates as maybe the current periods
tax is higher/lower depending on if the effective tax rate is higher/lower than the
marginal tax not right to assume that firm will continue to this in the future
(eventually they should be equal)
Effect of Net Operating Losses
For firms with large net operating losses carried forward or continuing operating losses:
o There is potential for significant tax savings in the first few years that they generate
positive earnings
There are 2 ways of capturing this effect:
1. Firms with current negative earnings (change (raise) the tax rate over time):
o Early on: zero taxes (losses carried forward offset income)
o As the net operating losses decrease Increase tax rates toward the marginal rate
o Tax rates used to compute both after-tax cost of debt and cost of capital need to
change. so in beginning when losses shelter income the tax rate used you cost of
capital and after-tax cost of debt should be zero.
2. Firms with positive earnings, but with a large net operating loss carried forward:
o Value the firm ignoring the tax savings generated by net operating losses,
Then, add to this amount the expected tax savings from net operating losses
o Expected tax savings= NOL*Tax
o Limitation: This assumes that the tax savings are both guaranteed and
o Firms need to generate earnings to create tax savings and there is
uncertainty about these earnings
Thus, this overestimates the tax savings
Important points on operating losses
o A potential acquirer can claim tax savings from net operating losses sooner than the
firm generates these losses
o This is a soure of ta serg
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