Pre and Post Tax

Discount Rates and Cash

Flows – A Technical Note
Wayne Lonergan

When discounting pre tax cash flows it is often assumed

that discounting pre tax cash flows at pre tax discount
rates will give the same answer as if after tax cash flows
and after tax discount rates were used. However, this is
not the case and material errors can arise, unless both the
cash flows and the discount rate are after-tax. Drawing
upon a series of analytical examples, common conceptual
flaws in discount rate and cashflow stream selection are
highlighted. In light of these, it is argued that discounted
cashflow analysis should be configured on the basis of after
tax cashflows discounted with after tax discount rates.

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THE JOURNAL OF APPLIED RESEARCH IN ACCOUNTING AND FINANCE

1. Introduction b. due to the difference between the timing of revenue and

expense recognition for accounting purposes and the time
This article examines the issues associated with the use of pre when cash receipts and cash outgoings actually occur.
and post tax discount rates in the conduct of analytical proce-
dures in which cashflow discounting is necessary. In particular, The accrual accounting model, the basis of accounting
the paper addresses the matter of problems which arise when adopted in most businesses (other than small, cash-based
inappropriate assumptions are made in relation to the estima- businesses), focuses on the acquisition and use of economic
tion and application of pre tax discount rates. resources in operations, not on their associated cash flows. For
example, although council rates may be paid once a year, un-
When discounting pre tax cash flows it is often assumed that der accrual accounting one twelfth of the amount is expensed
discounting pre tax cash flows at pre tax discount rates will each month.
give the same answer as if after tax cash flows and after tax
discount rates were used. However, this is not the case and The divergence between pre-tax income and cash flows and
material errors can arise, unless both the cash flows and the its consequence on the pre-tax approach is exacerbated by a
discount rate are after-tax. number of issues, including that:

For the reasons outlined below, the preferred (and technically a. depreciation and capital equipment purchases and dispos-
correct) method to discount cash flows is to express cash flows als are not coterminous; and
forecasts on an after tax basis, and to discount those cash
b. the existence of permanent tax differences (PMT) and
flows using an after tax discount rate.
temporary timing differences (TTD).
The article is structured as follows. Section 2 discusses is-
The flaw of the pre-tax approach is best understood if debt is
sues relating to the need for consistency in the selection of
assumed to be zero, and PMT and TTD are put aside, for the
discount rates to be applied to streams of cashflows. Section
sake of simplicity and illustration. In which case, the differ-
3 discusses problems associated with the calculation of pre
ence between pre-tax income and pre-tax cash flow is mainly
tax cashflows, while Section 4 highlights the problems inher-
attributable to:
ent with the estimation of pre tax discount rates. Section six
includes a series of analytical examples which clearly demon- a. movements in working capital
strate the errors which can arise in valuations where the con-
ceptual errors outlined in sections 2, 3 and 4 are not avoided. b. tax depreciation
Some brief conclusions are offered in Section 6.
c. tax losses (if any)

d. capital expenditure (and capital receipts).

2. Consistency between cash flows and
By definition, post-tax cash flow is equal to pre-tax cash flow
discount rate less tax. Pre-tax income is not always equal to pre-tax cash
flow due to the foregoing factors. Therefore, tax payable,
To ensure consistency between the cash flows and the discount
which is determined by multiplying the marginal corporate tax
rate used, the cash flows and the discount rate should be
rate (e.g. 36 percent) by pre-tax income, is generally differ-
expressed on a consistent basis. That is, after tax cash flows
ent from pre-tax cash flow multiplied by the marginal corpo-
must be discounted at after tax discount rates. There are a
rate tax rate.
number of fundamental reasons why this is so:
It mathematically follows that multiplying pre-tax cash flow
a. rates of return on equity investments are only observable
by a factor equal to one less the marginal corporate tax rate is
on an after company tax basis
generally not equal to post-tax cash flow. This proposition can
b. the capital asset pricing model (CAPM), from which dis- be further reinforced by deriving a mathematical relationship
count rates are derived, is based on stock market return between pre-tax cash flow and post-tax cash flow. The deriva-
of shares, which returns are calculated after company tion is presented below.
tax, and
In this derivation, the following notations are used:
c. as a matter of logic, like should be compared with like.
CFAT Post-tax cash flow
CFBT Pre-tax cash flow
OC Operating cost (excluding depreciation /
3. Calculating pre-tax cash flows amortisation)
OR Operating revenue
Implicit in the approach based on discounting pre-tax cash T Corporate tax rate
flow at pre-tax discount rate is the proposition that pre-tax
TD Tax depreciation
cash flow can be obtained by grossing up post-tax cash flow
TL Tax losses
at a rate equal to one less the marginal corporate tax rate,
or conversely, post-tax cash flow is simply pre-tax cash flow TP Tax paid
multiplied by a factor equal to one less the marginal corporate ΔWC Changes in working capital
tax rate. Capex Capital expenditure

This proposition is not always correct because it ignores the

divergence between pre-tax income, which is used for tax as-
sessment, and pre-tax cash flow. This divergence arises:

a. because cash flows may differ significantly from profits

due, for example, to working capital movements and the
timing of capital equipment purchases, etc
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 Pre and Post Tax Discount Rates and Cash Flows – A Technical Note

CFBT = OR – OC + ΔWC – Capex (1)

CFAT = CFBT – TP (2)
TP = (OR – OC – TD – TL) x T (3)
Substituting (3) into (2) yields
CFAT = CFBT – (OR – OC – TD – TL) x T (4)
Rearranging (1) gives
(OR – OC) = CFBT – ΔWC + capex (5)
Substituting (5) into (4) yields
CFAT = CFBT – (CFBT – ΔWC +Capex – TD – TL) x T (6)
CFAT = CFBT – CFBT x T + (ΔWC –Capex + TD + TL) x T
Collecting terms and rearranging gives
CFAT = CFBT (1 – T) + (ΔWC –Capex + TD + TL) x T (7)

Equation (7) sets out a theoretical relationship between pre-tax cash flows (CFBT) and post- tax cash flows (CFAT). It is clear that
CFAT is equal to CFBT (1-T) only if the second term of Equation (7), i.e. (ΔWC – Capex + TD + TL) x T, is zero. This is generally not
the case because there is no reliable relationship between working capital, capital expenditure, tax depreciation and tax losses.

A limited circumstance under which the second term of Equation (7) might be zero is mature profitable businesses where there is
likely to be no change in working capital requirement and depreciation is likely to be equal to capital expenditure. This is consistent
with the examples of no growth perpetual cash flow scenarios discussed below.

The following numerical example shows that post-tax cash flow is not equal to pre-tax cash flow multiplied by a factor equal to one
less the marginal corporate tax rate:

Pre-tax calculation Tax Post-tax calculation

Revenue 100,000 Revenue 100,000 Pre-tax cash flow 20,000
Less cost 50,000 Less cost 50,000 Less tax paid 10,500
Less change in WC 10,000 Less tax 15,000 Post-tax cash flow 9,500
depreciation
Less Capex 20,000 Less tax losses Nil
Pre-tax cash flow 20,000 Pre-tax income 35,000
Tax rate 30%
Tax paid 10,500

Pre-tax cash flow x (1 – 0.30) = $14,000* ≠ $9,500 = post-tax cash flow

* Being $20,000 x 0.7

4. Calculating pre tax discount rates

Pre tax discount rates are often (but incorrectly) calculated by grossing up the after tax discount rate by one less the marginal
corporate tax rate. On this basis, an after tax discount rate of 14% per annum, assuming a tax rate of 30%, equals a pre tax discount
rate of 20% per annum.

However, there are various difficulties in undertaking a pre tax discounted cash flow (DCF) analysis. In summary, the grossing up for-
mula used to derive pre tax discount rates is an over-simplification and only holds under limited circumstances.

Firstly, there is no practical reliable method to calculate a pre tax discount rate, and they can not simply be calculated by grossing
up the after tax discount rate. Secondly, investors are interested in after tax rather than pre tax returns. Furthermore, the vari-
ables used to calculate the cost of equity (including beta and the market risk premium) are based on movements in company stock
prices which are based on companies after tax (not pre tax) results.

The CAPM variables of the cost of equity and the pricing of company shares are therefore measured on an after tax basis. Thus it is
simply not possible to empirically verify pre tax rates of return for equities and similar assets.

5. Analytical Examples
The following examples show that there are fundamental errors when calculating the present value of cash flows using pre-tax
discount rates

In particular, the examples show that adjusting an after tax discount rate to calculate a pre-tax discount rate using the above gross
up formula will only lead to the same values being determined on a before and after tax basis when the cash flows are in perpetuity
with no growth.

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While grossing up pre-tax cash flow to obtain post-tax cash flow may, as shown above, be appropriate only in the case of cash
flow perpetuities with no or constant growth, in order to ease the exposition of the inappropriateness of using grossed-up pre-tax
discount rate alone, in all the examples it is assumed, for the purpose of illustration that post-tax cash flow is equal to pre-tax cash
flow multiplied by a factor equal to one less the marginal corporate tax rate.

All examples also assume an after tax discount rate of 14% per annum, a tax rate of 30% and a pre tax discount rate of 20.0% per
annum (being 14% divided by 1 less 0.30).

Where a perpetuity calculation is performed for a mature series of cash flows, i.e. no growth, the present value under pre and
after-tax calculations is equivalent, as demonstrated below:

Example 1 - Cash flows in Perpetuity – No Growth

Pre tax calculations After tax calculations

Pre tax cash flow $20,000 After tax cash flow $14,000
Pre tax discount rate 20.0% After tax discount rate 14%
Present value $100,000(1) Present value $100,000(2)

Note:
1 $20,000/20% = $100,000
2 $14,000/14% = $100,000

The next calculation assumes cash flows grow in perpetuity at 5% per annum:

Example 2 - Cash flows in perpetuity – 5% Growth

Pre tax calculations After tax calculations

Pre tax cash flow $20,000 After tax cash flow $14,800
Growth rate (pa) 5%(1) Growth rate (pa) 5%(1)
Pre tax discount rate 20% After tax discount rate 14%
Present value $140,000(2) Present value $163,333(3)

Note:
1 Strictly speaking, the same growth rate can be applied to pre-tax and post-tax cash
flows only if (i) post-tax cash flow is equal to pre-tax cash flow multiplied by one less
the marginal corporate tax rate; and (ii) the marginal corporate tax rate is constant.
2 $20,000 x 1.05/(20% - 5%) = $140,000.
3 $14,000 x 1.05/(14% - 5%) = $163,333.

As shown above the present values differ by a material margin depending on whether the calculation is undertaken on a pre or post
tax basis. It is also possible to demonstrate similar phenomena focusing only on single period cashflows. The following table calcu-
lates the present value of a cash flow in one year’s time, calculated on both a pre and post tax basis:

Example 3 – Single Period Cashflows

Pre tax calculations After tax calculations

Pre tax cash flow $20,000 After tax cash flow $14,000
Pre tax discount rate 20% After tax discount rate 14%
Present value $16,667(1) Present value $12,281(2)

Note:
1 $20,000/1.2 = $16,667.
2 $14,000/1.14=$12,281.

Again, it is clear from this example that grossing up the discount rate by 1 less the tax rate to discount pre tax cash flows does not
result in a similar present value calculated using after tax cash flows and discount rates.

Furthermore, it is illogical that an investor would pay more than the after tax cash flow return. Consequently, the pre tax calcula-
tion must be fundamentally flawed given that the present value of the pre tax cash flow (i.e. $16,667) exceeds the after tax value
of the cash flow even if it was received immediately (i.e. $14,000).

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 Pre and Post Tax Discount Rates and Cash Flows – A Technical Note

A similar pattern may be observed when contemplating multi period cashflows. The following example shows a five year cash flow,
discounted using pre tax cash flows and discounts rates, and after tax cash flows and discount rates.

Example 4 – Multi Period Cashflows

Pre tax calculations:

Pre tax
Cash flow PV factor Present value
Year $ at 20% pa $
1 20,000 1.20 16,667
2 25,000 1.44 17,361
3 30,000 1.728 17,361
4 35,000 2.0736 16,879
5 40,000 2.4883 16,075
Total value 84,343

Post tax calculations:

Post tax
Cash flow PV factor Present value
Year $ at 12.8% pa $
1 14,000 1.114 12,281
2 17,500 1.2996 13,466
3 21,500 1.4815 14,174
4 24,500 1.6890 14,506
5 28,000 1.9254 14,542
Total value 68,969

Again, the pre and post tax present values are materially different, if the naïve grossed up pre-tax discount rate is applied.

6. Conclusion
This article has argued that there are fundamental errors in calculating the present value of cash flows using pre-tax cash flows and
discount rates. There are only a few special cases where this approach may give the same answer as discounting after tax cash flows
at after tax discount rate, for instance the case of cash flows in perpetuity with no growth. A series of analytical examples set out in
section 5 clearly demonstrate this. Consequently, it is important that after tax cash flows and after tax discount rates are applied in
DCF valuations. JARAF

Wayne Lonergan is Managing Director of Lonergan Edwards and

Associates Limited. He has specialised in valuations, consequential
loss assessments and litigation support work for 35 years.

Wayne is an Adjunct Professor at the University of Sydney and has

held numerous statutory and professional appointments including
memberships, over many years, of the Companies and Securities
Advisory Committee, Australian Accounting Standards Board and
International Accounting Standards Subcommittees on Financial
Instruments. He has also held numerous and senior roles in the
Securities Institute of Australia, including three years as National
President and Chairman of several subcommittees on capital market
related matters. He is presently a member of the International
Financial Reporting Interpretations Committee of the International
Accounting Standards Board.

Wayne Lonergan is widely acknowledged as the leading Australian

expert in the area of corporate and business valuations.

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