From Earnings to Cashflows: Taxes and R

1
From Earnings to CashflowsTaxes and RD
P.V. Viswanath
Valuation of the Firm
2
Tax Rates

• In computing FCFF, we need to separate financing
  flows from operating flows.
• There are two reasons
• One, we need the cashflows to the entire firm
  both bondholders and stockholders.
• Two, the tax benefits of debt are taken into
  account in the discount rate.
• Hence we need to estimate the tax hit to the
  unlevered firm. We cannot use actual taxes
  paid.
• This means we need a measure of the tax rate.

3
Tax Rates

• There are two possible alternatives
• The effective tax rate, i.e. taxes due/taxable
  income
• The marginal tax rate the tax rate the firm
  faces on its last dollar on income.
• Including federal, state and local taxes, the
  marginal tax rate can be 40 or higher.
• The effective tax rate can be lower or higher for
  several reasons.

4
Tax Rates

• Different accounting standards are used for
  reporting and tax purposes.
• Straight line depreciation may be used for
  reporting purposes to show higher income, but
  accelerated depreciation may be used to reduce
  taxable income.
• Since the effective tax rate is based on actual
  taxes paid, it will be lower in this case than
  the marginal tax rate since the denominator will
  be higher than the income number on which the
  actual tax payment is based.

5
Deferred Tax Liability

• In this case, a deferred tax liability will be
  created.
• According to the reported numbers, taxable income
  is higher and taxes due is higher.
• However, actual tax paid is lower because taxable
  income is lower.
• Hence a deferred tax liability is created.
• Theoretically, this will reduce over time, as
  capital expenditures taper off.
• However, if a company keeps growing, deferred tax
  liabilities may even increase.

6
Deferred Tax Liability Example

• Fairly asset-intensive companies like Kroger
  (NYSE KR) generally have to build more grocery
  stores in order to increase their revenues.
• Thus, Kroger's PPE base increases over time, and
  the difference in speeds between shareholder and
  taxable depreciation methods tends not to
  reverse.
• In 2001, Kroger reported 401 million in DTLs
  related to depreciation differences. Five years
  later, instead of dwindling away, DTLs had
  increased to 1.1 billion.
• http//www.fool.com/investing/general/2007/01/12/u
  nderstanding-deferred-tax-liabilities.aspx

7
Deferred Tax Asset

• Warranties, restructuring charges, net operating
  losses, unrealized security losses can create
  future tax benefits.
• For example, companies like Circuit City and Best
  Buy (BBY) sell electronics that have multi-year
  warranties.
• These companies estimate future warranty expenses
  based on how many returns they think they'll get
  this number is used in reported income.
• However, the IRS does not allow warranty expenses
  to be recognized until the actual event occurs
  so, shareholder income is lower than taxable
  income.
• This causes a deferred tax asset BBY "prepaid"
  warranty taxes and will receive a future benefit
  (lower taxes) when the warranty event actually
  occurs.
• http//www.fool.com/investing/general/2007/01/09/u
  nderstanding-deferred-tax-assets.aspx

8
Are these true liabilities?

• If the liabilities are unlikely to be reversed,
  then they should be treated like equity.
• Thus, taxes on unrealized capital gains that may
  never be paid are closer to equity.
• Berkshire Hathaways stake in American Express,
  had a cost basis of 1.3 billion, but was worth
  nearly 9 billion in early 2007. The gain of 7.7
  billion is taxable, and if we assume that, upon
  the sale, Berkshire will have to pay a 35
  capital gains tax on its windfall, we'd have to
  set up a 2.7 billion deferred tax liability to
  reflect Berkshire's potential future tax
  payments.
• However, because Berkshire may never sell, the
  DTLs on these long-term holdings may be
  considered close to equity.

9
Deferred Tax Assets

• According to a recent study, the most important
  components of deferred tax assets are
• Employment and post-employment benefits accrued
  employee benefits are counted as expenses for
  reporting purposes, but not expensed for tax
  purposes. This creates a deferred tax asset.
• Loss and credit carry-forwards current losses
  can be used to off-set future income. If there is
  no future income, these loss carry-forwards will
  expire worthless.
• A firm is required to evaluate the likelihood of
  being able to recoup these tax benefits.
  Valuation allowances are created as contra-assets
  to adjust for these Deferred Tax Assets.
• The financial analyst has to make an independent
  evaluation of DTAs and Valuation Allowances.
• http//papers.ssrn.com/sol3/papers.cfm?abstract_id
  964886PaperDownload

10
Cash-flow implications

• For FCFE computations, we start our cashflow
  computation from reported Net Income.
• Hence, if we have deferred tax liabilities going
  up, this means that we have overestimated tax
  cash outflows.
• We should treat this the same way that we would
  treat an increase in Accounts Payable that is,
  it increases cashflows.
• This implies that we need to forecast DTAs and
  DTLs, particularly if they are large or if they
  are likely to change in the near future.
• If they are small or if they are unlikely to
  change, we might be able to ignore them.

11
Tax Rates and FCFF

• So, for FCFF calculations, what tax rate should
  be used in computing after-tax operating income?
• Differing assumptions can lead to very different
  conclusions (Illustration 10.1 of Damodarans
  Investment Valuation)
• When a DTL is created, the effective tax rate is
  lower than the marginal tax rate.
• Thus, if reported depreciation is lower, actual
  taxes paid will be lower than taxes due and
  reported income will be higher than taxable
  income.
• If the DTL will ultimately be erased, as when
  capital expenditures taper off, then the
  effective tax rate will go up over time.
• Solution look at the nature of DTLs and DTAs,
  especially prospectively and then decide how to
  allow for changing tax rates going forward.

12
RD Expenses Operating or Capital Expenses

• Accounting standards require us to consider RD
  as an operating expense even though it is
  designed to generate future growth. It is more
  logical to treat it as capital expenditures.
• An approach to capitalizing RD (cost-based)
• Specify an amortizable life for RD (2 - 10
  years)
• Collect past RD expenses for as long as the
  amortizable life
• Assume RD expenses incurred at the end of yr
• Sum up the unamortized RD over the period.
  (Thus, if the amortizable life is 5 years, the
  research asset can be obtained by adding up 1/5th
  of the RD expense from four years ago, 2/5th of
  the RD expense from three years ago...

13
Capitalizing RD Expenses Boeing
Assuming a ten year life thus, RD expenses for
1998 will be amortized over the 1999-2008 period.
14
Boeings Corrected Operating Income
For 1998
Data obtained from Income Statement Data
obtained from Income Statement see also previous
slide In principle, it could be argued that RD
capitalized values should be restated in 1998
dollars, instead of using the raw unamortized
portions of RD outlays in past years however,
the current procedure may be defended on the
grounds of conservatism.
15
Boeings Corrected Balance Sheet

• There will be the following modifications on the
  balance sheet
• There will be a new asset, RD, that will show on
  the assets side. If one wants to show the gross
  value of RD and accumulated amortization,
  however, that will require computation of the
  amortization in each year for as many years as
  the amortizable life of the RD.
• Corresponding to that, the value of stockholders
  equity will be higher by the same amount.
• In our example, this amount will be 9,100.

16
The Effect of Capitalizing RD

• Operating Income will generally increase, though
  it depends upon whether RD is growing or not. If
  it is flat, there will be no effect since the
  amortization will offset the RD added back. The
  faster RD is growing the more operating income
  will increase.
• Net income will increase proportionately,
  depending again upon how fast RD is growing.
  Adjusted Net Income will also have to take the
  tax deductibility of RD into account.
• Book value of equity (and capital) will increase
  by the capitalized Research asset
• Capital expenditures will increase by the amount
  of RD Depreciation will increase by the
  amortization of the research asset for all
  firms, the net cap ex will increase by the same
  amount as the after-tax operating income.

17
Tax Benefits of RD Expensing

• RD outlays are more like capital expenditures,
  because their benefits will be obtained over
  time however, they are allowed to be expensed
  immediately.
• Hence we should make sure to include the tax
  benefits of such expensing in computing after-tax
  operating income even if we do capitalize the RD
  expenditures.
• The pre-tax operating earnings will take into
  account RD expense.
• Hence, Adjusted After-tax operating earnings
  (Reported Pre-tax operating earnings)(1-t)
  Current years RD expense Amortization of
  research Asset
• This issue is not relevant for the FCFE approach
  since we start with Net Income, and taxes are
  automatically taken into account.

18
Income from Investments and Cross-holdings

• Firms sometimes buy and sell securities in order
  to manage earnings. Selling securities that have
  increased in market value can increase earnings
  per share.
• Similarly, interest and dividends from holdings
  in other firms or from other securities also
  affect earnings.
• These should not be taken into account in
  computing the core value of the firm. Rather,
  their value should be added back to the value of
  the core firm as established by the appropriate
  DCF valuation.