From Earnings to Cashflows:
Taxes and R&D
P.V. Viswanath
Valuation of the Firm
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.
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.
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.
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.
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/understandi
ng-deferred-tax-liabilities.aspx
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/understanding-deferred-taxassets.aspx
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 Hathaway’s 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.
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 offset future income. If there is no future income, these loss carryforwards 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=964886#PaperDownload
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.
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 Damodaran’s 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.
R&D Expenses: Operating or Capital Expenses
Accounting standards require us to consider
R&D 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 R&D (cost-based)
Specify an amortizable life for R&D (2 - 10 years)
Collect past R&D expenses for as long as the
amortizable life
Assume R&D expenses incurred at the end of yr
Sum up the unamortized R&D over the period.
(Thus, if the amortizable life is 5 years, the
research asset can be obtained by adding up
1/5th of the R&D expense from four years ago,
2/5th of the R&D expense from three years ago...:
Capitalizing R&D Expenses: Boeing
Assuming a ten year life; thus, R&D expenses for 1998
will be amortized over the 1999-2008 period.
Year
R&D Outlay
Unamortized Portion
at end 1998
Amortization for
1998
Value
1988
751
0
0
75.1
1989
754
0.1
75.4
75.4
1990
827
0.2
165.4
82.7
1991
1417
0.3
425.1
141.7
1992
1846
0.4
738.4
184.6
1993
1661
0.5
830.5
166.1
1994
1704
0.6
1022.4
170.4
1995
1300
0.7
910
130
1996
1633
0.8
1306.4
163.3
1997
1924
0.9
1731.6
192.4
1998
1895
1
1895
0
Capitalized value of R&D for 1998 =
9100.2
Total R&D Amortization Expense for 1998 =
1381.7
Boeing’s Corrected Operating Income
For 1998
Operating Income*
$1,720.00
+ Research and Development Expenses**
$1,895.00
- Amortization of Research Asset**
$1,381.70
= Adjusted Operating Income
$2,233.30
* Data obtained from Income Statement
** Data obtained from Income Statement; see also previous slide
In principle, it could be argued that R&D capitalized values
should be restated in 1998 dollars, instead of using the raw
unamortized portions of R&D outlays in past years; however,
the current procedure may be defended on the grounds of
conservatism.
Boeing’s Corrected Balance Sheet
There will be the following modifications on
the balance sheet:
There will be a new asset, R&D, that will show on
the assets side. If one wants to show the gross
value of R&D and accumulated amortization,
however, that will require computation of the
amortization in each year for as many years as the
amortizable life of the R&D.
Corresponding to that, the value of stockholder’s
equity will be higher by the same amount.
In our example, this amount will be $9,100.
The Effect of Capitalizing R&D
Operating Income will generally increase, though it
depends upon whether R&D is growing or not. If it is
flat, there will be no effect since the amortization will
offset the R&D added back. The faster R&D is growing
the more operating income will increase.
Net income will increase proportionately, depending
again upon how fast R&D is growing. Adjusted Net
Income will also have to take the tax deductibility of
R&D into account.
Book value of equity (and capital) will increase by the
capitalized Research asset
Capital expenditures will increase by the amount of
R&D; 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.
Tax Benefits of R&D Expensing
R&D 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 R&D expenditures.
The pre-tax operating earnings will take into account R&D
expense.
Hence, Adjusted After-tax operating earnings = (Reported
Pre-tax operating earnings)(1-t) + Current year’s R&D
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.
Income from Investments and Crossholdings
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.