Corporate and Project Finance Modeling

Chapter 31Computing Normalized Deferred Tax Changes

Financial analysts are sometimes intimidated by working through issues associated with deferred taxes because of all of the accounting techniques that underlie the calculation. Yet errors and inconsistencies in modeling deferred taxes can result in big valuation biases. Without too much accounting and using concepts introduced in earlier chapters, you can work through the deferred taxes and develop a level of normalized deferred tax changes that is consistent with the terminal growth rate. As explained in Chapter 25 when discussing the bridge between enterprise value and equity value, deferred taxes associated with accelerated depreciation should be directly included in the calculation of free cash flow and should not be part of the bridge between enterprise value and equity value. If increases in deferred tax liability are added to the free cash flow, value is higher as compared to the cash with no deferred taxes. However, if the inappropriate assumption is made that accumulated deferred tax should be treated as a debt like liability, the value is less than it would be if there were no deferred tax. Other deferred tax items that arise from free cash flow items such as warranty provisions should also be part of the free cash flow analysis.

For the case of deferred taxes associated with acceleration of tax depreciation where the tax depreciation rate is greater than the book depreciation rate, taxes paid are less than taxes ...