The problem is, how do you calculate the pre-tax cost of equity? It’s an estimate and is not equal to: This is a fundamental principle that many are either unaware of or else forget. It is common practice that if you discount pre-tax cash flows at the pre-tax discount rate, the NPV of this calculation must equal the NPV of evaluating the post-tax cash flows at the post-tax discount rate. If I have a project with a post-tax NPV of $700 and a tax rate of 30%, many will calculate the pre-tax NPV to be $1,000, being $700 divided by (1 – 30%). Sometimes, such as comparing two projects in different tax regimes, it’s advantageous to evaluate projects or companies pre-tax. We can then calculate the blended rate known as the weighted average cost of capital (WACC): Post-tax cost of debt = Pre-tax cost of debt × (1 – tax rate).įor example, if the pre-tax cost of debt is 8% and tax is charged at 30%, then the post-tax cost of debt will be 8% × (1 – 30%) = 5.6%. Allowing for simplifying assumptions, such as the tax credit is received when the interest payment is made, this allows us to use the formula: We have to compare apples with apples, so since we live in an after-tax world, we need to quote the cost of debt after tax, too. suffice to say that this rate is always estimated post-tax because the underlying market data are post-tax. This is not an article per se on valuation, so I won’t start a long monologue on betas, correlations, et al. The most frequently used is the capital asset pricing model (CAPM). It’s the required rate of return for the shareholders, and there are several methods of estimating it. However, cost of equity is usually a more complex beast. The cost of debt, in the simplest scenario, can be easy to identify: It’s the marginal cost of borrowing the next $1. This discount rate may be a mix of both debt and equity. The aim is to generate a positive return (a positive NPV) for a given rate of discounting, known as the discount rate. Adding up all these positive and negative present values provides a net total: the NPV. Valuations include both cash inflows and cash outflows. Each assumption will obviously vary the overall valuation as a consequence. The three most common assumptions are at the start, the middle, and the end of the period in question. We must understand when we assume the cash flows will occur. Note that all of these valuations are for a point of time, not a period. However, they are all worth the equivalent of $100 now (as we discount these future values back to their present values).Something that costs $121 in that year will cost 10% more the following year, ie, $133.10.Something that costs $110 next year will cost 10% more the year after, ie, $121.Something that costs $100 this year will cost 10% more next year, ie, $110.Let’s assume inflation is running at 10% (and we will assume this is after tax, as we all earn our wages after tax, and increases in spending affect this after-tax wage).Perhaps the easiest way to think of it is as follows: However, one is arguably more common than the rest these days - net present value (NPV) using discounted cash flows.Īs many readers will know, the idea of a discounted cash flow (DCF) is a simple one. Many techniques can be employed to value an asset, a project, a business, a shareholding, and so on. And Excel is probably the most common software for this purpose. No matter what the technique used, access to valuation software is crucial. If you have ever been involved in a valuation, you will appreciate that a financial model is never far away.
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