Taxes and Discounted Cash Flow (DCF)

Companies have to pay a wide variety of taxes. They can be treated in a similar way to disbursements for factors of production, they reduce the cash flows, and as a result the present value of the free cash flows is also lower than if there were no taxes. The present value of the free cash flows is also lower because the company has to pay the electricity bill, and the company value would be higher if energy could be obtained free of charge in the country in question. The example is no irony: Companies that use a lot of electricity (aluminum production) relocate theirs Location in countries with low energy prices. The formula, including the formula for the cost of capital, remains unaffected by all of these considerations.

Taxes are an issue with the DCF method because in certain cases they are not finance-neutral. This means that taxes treat equity and borrowed capital differently, and that therefore the value of the company depends on the capital structure and varies with the level of indebtedness.
For a very concrete, specific capital structure, the following applies: The formula that the value of equity is equal to the present value of free cash flows is still valid, and that is now a cash flow after taxes.
The same applies to the entity method, as before, that the total value (equity plus borrowed capital) is equal to the sum of the present values of the free cash flows plus the interest, and the taxes have already been deducted from the cash flows. With the entity method, the rate of average cost of capital to be used for discounting is again given by the weighted sum of the cost of equity and the cost of debt.

Die alten Formeln bleiben also für eine konkrete Kapitalstruktur gültig. Kompliziert wird die Thematik der Steuern, wenn die eben für eine konkrete Kapitalstruktur beantwortete Frage nach dem Wert verallge-meinert werden soll, und wenn der Wert für alle Verschuldungsgrade durch eine analytische Formel ausgedrückt werden soll. Das ist recht komplex. Schon wenn für eine Unternehmung verschiedene Szenarien hinsichtlich der financing gerechnet werden, zeigt sich: Mit dem Verschuldungsgrad verändert sich:

1. The cash flow (due to profit taxes),

2. The interest to be paid (because more interest is to be paid if the debt is higher),

3. The average cost of capital (because the relative weights of equity and debt change),

4. The value of the company.

One can hardly hope that all four effects can be represented in a closed formula. Nevertheless, there are always formulas in which the average cost of capital is defined as follows:

WACC = EK / GK * kEK + FK / GK * kFK * (1-s)

EK = equity

FK = framd capital

GK = total capital

kEK = cost of equity

kFK = cost of debt

s = corporate level tax rate

Here s denotes the tax burden. In this formula, the cost of capital is always lower with external financing, and it can therefore only be correct if the DCF approach does not include the free cash flows in the numerator, but values that are just as smaller than the true free cash flows. Most of the time, taxation is assumed that is greater than the taxes actually to be paid, precisely because there is no double taxation of the added value that is offset by the interest paid.

In the specific case, however, a detailed consideration is advisable. We have to content ourselves with a few remarks, which concern primarily the fourth point:
Of course, equity investors as well as debt investors must pay tax on income. Investors therefore have no particular preference as to whether the results they receive from an investment are declared as equity or as debt. However, it is the case in many countries that interest income is taxable in full as income, while results from an investment of own resources are only taxable as income to the extent that they are received in the form of dividends.

Insofar as these results are recorded as an increase in market value (price gains), the private investor does not have to pay any income tax on them (unless certain speculation periods are not observed). Overall, these tax conditions mean that private investors 1. prefer to make their money available as equity (such as shares) rather than outside capital (such as bonds or as a shareholder loan), and that they 2. prefer it if the company does not distribute any profits, it is retained and (in the interests of the owner) invested or, if there is a lack of ideas and profitable projects, financial investments are made.

On the other hand, an enterprise has to pay tax on profits in all countries, while the economic performance that is in opposition to the interest is essentially not taxable because interest as an expense diminishes profit. A company would therefore try to present its economic performance in terms of interest rather than profits.

In some countries, for example in the USA and Switzerland, there is actually double taxation. The firm pays taxes on the profits, and the equity investors pay taxes again when they receive the profits (in any form).

In contrast, the company pays no taxes on the economic results on which it pays interest. Interest is only taxed once if it is received by the investor. There is also something else: a large part of the borrowed capital is provided by pension funds and social security institutions, which do not have to pay any tax on the interest collected, and the insured often have certain tax exemptions because private pension provision is to be promoted in this way . In other countries, such as Germany, the shareholder receives a tax credit. This corrects the double taxation again.

All in all:

Economic results, which are attributed to equity due to the capital structure, are taxed between 0.5 and 2 times depending on the country and dividend policy.

Economic results that are added to debt are subject to between 0 and 1 times the tax.

This does not make the determination of an optimal capital structure easy and actually prohibits a closed formula for the DCF.

In praktische Fällen muß jedoch die Steuergutschrift eigens berücksichtigt werden. Dann wären bei der Equity method die Cashflows (nach Steuern), abzüglich der geplanten Investitionen, plus eventueller Steuergutschriften zu diskontieren. Für die Diskontierung wäre der Eigenkapitalkostensatz heranzuziehen. Bei der Entity-Methode wären zu diskontieren die Cashflows (nach Steuern), abzüglich der geplanten Investitionen, plus eventueller Steuergutschriften plus Zinszahlungen. Für die Diskontierung wären die durchschnittlichen Kapitalkosten WACC, wie definiert, heranzuziehen.

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