The implications for valuation are simple. If we use the
dividenddiscountmodelanddonotallowforthebuildupof
cashthatoccurswhenfirmspayoutlessthantheycanafford,
we will underestimate the value of equity in firms.
CONCLUSION
When valuing a firm, the cash flows that are discounted
shouldbeaftertaxesandreinvestmentneedsbutbeforedebt
payments. Whenvaluing equity, the cash flowsshould be
afterdebtpayments.Inthischapter,weconsideredsomeof
the challenges in coming up with these numbers for firms.
We began the chapter by looking at the limitations of
accountingmeasuresofearningsandhowbesttoadjustthese
earningsfor miscategorized itemssuch as operating leases
andR&D.Tostatethisoperatingincomeinafter-taxterms,
weneeda taxrate.Firmsgenerallystatetheireffectivetax
ratesintheirfinancialstatements,buttheseeffectivetaxrates
can be different from marginal tax rates. Whereas the
effective tax rate can be used to arrive at the after-tax
operating income in the current period, the tax rate used
shouldconvergeonthemarginaltaxratein futureperiods.
Forfirmsthatarelosingmoneyandnotpayingtaxes,thenet
operatinglossesthattheyareaccumulatingwillprotectsome
of their future income from taxation.
Thereinvestmentthatfirmsmakeintheirownoperationsis
thenconsideredintwoparts.Thefirstpartisthenetcapital
expenditure of the firm, which is the difference between
capital expenditures (a cash outflow) and depreciation
(effectivelyacashinflow).Inthisnetcapitalexpenditure,we
includethecapitalizedoperatingexpenses(suchasR&D)and