Chapter 12 : Income Tax and Net Cash Flow

The hardest thing in the world to understand is the income tax.

Albert Einstein

The Income Tax Rate is the rate at which taxes are levied on the operating profit of any business/company. It is the operating cash outflow for the company and the eighth step in the process of valuation.

Income Tax during the Forecast Period

The Income Tax levied in the latest financial accounts is the Cash Income Tax. There could be a difference in the cash income tax rate seen in the latest financials and the statutory income tax rate. This is usually due to company accounting policies of recognizing certain revenue and expenses at different times, for financial accounts and tax accounts. Ideally, one can use the latest statutory income tax rate during the forecast period to even out matters.

The income tax rate has a significant impact on valuation. When the honourable Finance Minister of India announced a corporate rate cut from 30% to 22%, the market zoomed by 15% in a few days.

Ideally use the latest Statutory Income Tax Rate and not the Cash Income Tax Rate as provided by the company to even out matters. The income tax rate has a significant impact on Valuation.

Income Tax Rate during Terminal Period

Terminal Period is the period post the forecast period. Income tax rate during the terminal period is the rate companies expect to pay during the post forecast period. This should be the Marginal Income Tax Rate. For instance, we can use 25.17% for India or 21% for the US in 2021, unless we believe that a change is coming.

In case the Income Tax during the Terminal Period is assumed to be different that that assumed during the Forecast Period that one needs to adjust this with Income Tax assumed during the Terminal Period and recompute the Free Cash Flow for the Target Year as this forms the Free Cash flows for the first year of the Terminal Period.

Example for Computing Net Cash Flow of Black Bay Pizza

Continuing with the example of Black Bay Pizza, we now prepare a Cash Flow Statement to determine the free cash flow for each year of the forecast period.

Table 7 illustrates the computation of Net Cash Flow for Black Bay Pizza based on the following assumptions:


Forecast Period 5 Years
Sales in Prior Period 1000
Sales Growth, CAGR 1-3 Years 15%
CAGR 4-5 Year 12%
Operating Profit Margin 1-2 Years 15%
Operating Profit Margin 3-5 Years 18%
Income Tax 25%
Incremental Fixed Assets Investment Rate 35%
Incremental Working Capital Investment Rate 30%

Table 7 - Computation of Net Cash Flow

Year 0 1 2 3 4 5
Sales 1,000 1,150 1,323 1,521 1,703 1,908
Operating Profit 172 198 273 306 343
Income Tax @25% 43 50 68 77 86
Incremental Fixed Assets @35% 53 60 69 64 72
Incremental Working Capital @30% 45 52 60 55 61
Net Cash Flow 32 37 76 111 125

Chapters 8 to 12 have focused on the essential parameters underlying cash flow from operations. To convert these cash flows to present value, we need to discount the net cash flows with cost of capital.