Taxes and Wacc in Cash Flow Based NPV and Profitability Analyses

Abstract

The purpose of this study is to contribute to the understanding of the complex phenomenon of tax effects in value and profitability analyses. The aim is to examine, describe and evaluate where and how taxes and relevant (for value) tax effects should be considered in value and profitability analysis based on discounted cash flow. This report deals with important and complicated issues:

- How should taxes be treated when dealing with value and profitability analysis of the past, today and the future?

- How do we incorporate effects from taxes into the framework of value and profitability analysis from a Value Based Management perspective?

How to properly deal with tax effects in value and profitability analysis is a difficult question. In some companies, the general opinion is that by neglecting tax effects, they are "being careful" - that they take a conservative approach. But, on the contrary, the problem is just being accelerated, which should come as no surprise. The calculation's value is often "out of control", but without the companies knowledge of it.

Whatever situation and whatever the aim of an analysis might be, it is important though to be aware of the general problems when dealing with taxes in value and profitability analysis. This report will therefore not cover the entire issue. However, it raises some important issues and presents some potential solutions.

A matrix has been developed for pedagogic reasons, the Tax/WACC matrix, displaying all possible and available combinations of tax treatment. By making your choices, you specify your preferred formula for calculating WACC, the outline in the cash flow.

Keywords: WACC, investment calculation, CVA, EVA, VBM, NPV, Value Based Management