Hi guys,
Think about a company that currently has losses carried forward in its BS.
When calculating income taxes, EBT should be ajusted to compensate part of this losses.
My question is: which tax rate should be used when calculating Beta and cost of debt in WACC? The "effective tax rate" or the nominal one?
Should we use a different WACC for each year, until the losses carried forward are fully compensated?
Thanks
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I may edit with better response.
This is a good question. Going back to the purpose of WACC - the WACC should be on the incremental tax rate - because the incremental interest from having debt offsets some tax. That is still true in the scenario you describe.
However - there is a nuance here - although the interest is shielding accounting tax, it is likely merely adding to the NOL, not providing an instant cash benefit. So in some sense, using the nominal tax rate WACC is overstating the time value of the interest expense tax shield
(This does not mean you should use the effective tax rate after NOL deduction and use different WACCs every year - I’m fairly confident that is not the right answer)
A first pass, “reasonable” and defendable valuation would use nominal tax rate WACC and defend with the first paragraph. The time value of the interest expense issue is probably not a big needle mover (using the wrong WACC would be a big needle mover though!
A real rigorous valuation would have to account for the second paragraph. A levered DCF to equity would account for this, but let me think if there is a way to do it with WACC
Also note - there isn’t a lot of pressure to get this exactly right in the sell-side or buy-side because frankly most aren’t pondering WACC to the extent you are. Using the abbreviated method (incremental tax rate WACC) would have been sufficient in all of the times I’ve encountered this in my IB and HF career
Thank you, very much.
I was once interviewed for an IB analyst position, and one of the associates asked me this: What are the impacts of NOLs on DCF and WACC calculation. I had never thought about this at that time, so I came up with the answer that considers a different WACC for each year.
But was not sure about this, and wanted to know what you guys think.
What do you mean by "abbreviated method (incremental tax rate WACC)"?
Thanks once again.
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