thetaxratesusedtocomputetheafter-taxcashflowscannot
changeovertime.Thus,invaluingafirmwithaneffective
taxrateof 24 percentinthecurrentperiodandamarginaltax
rateof 35 percent,wecanestimatethefirstyear’scashflows
usingtheeffectivetaxrateof 24 percentandthenincreasethe
taxrateto 35 percentovertime.Itiscriticalthatthetaxrate
used in perpetuity to compute the terminal value be the
marginal tax rate.
When valuing equity, we often start with net income or
earnings per share, which are after-tax earnings. While it
lookslikewe canavoiddealing with theestimation oftax
rates when using after-tax earnings, appearances are
deceptive.Thecurrentafter-taxearningsofafirmreflectthe
taxespaidthisyear.Totheextentthattaxplanningordeferral
causedthispaymenttobeverylow(loweffectivetaxrates)
or very high (high effectivetax rates),we runthe risk of
assumingthatthefirmcancontinuetodothisinthefutureif
wedonotadjustthenetincomeforchangesinthetaxratesin
future years.
ILLUSTRATION3.4: Effect of TaxRate Assumptions on
Value
Convoy Inc. is a telecommunications firm that generated
$150millioninpretaxoperatingincomeandreinvested$30
millionin themostrecentfinancialyear.As aresultoftax
deferrals,thefirmhasaneffectivetaxrateof20%,whileits
marginaltaxrateis40%.Boththeoperatingincomeandthe
reinvestmentareexpectedtogrow10%ayearforfiveyears
and 5%thereafter.Thefirm’s cost ofcapitalis 9%and is
expectedtoremain unchangedovertime. Wewillestimate
thevalueofConvoyusingthreedifferentassumptionsabout