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.
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:
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.