Cost of Capital: Applications and Examples, + Website, 5th Edition

CHAPTER 37

Adjusting the Discount Rate to Alternative Economic Income Measures

Introduction

Converting from Capitalizing Net Cash Flow to Capitalizing Another Economic Income Measure

Converting After-Tax Rates with Zero or Constant Growth

Converting After-Tax Capitalization Rates

Converting After-Tax Capitalization Rates to Pretax Capitalization Rates

Converting After-Tax Discount Rates with Constant Growth

Converting After-Tax Rates with Changing Growth

Summary

Additional Reading

INTRODUCTION

Throughout most of this book, we have focused on deriving a discount rate applicable to net cash flow. In some situations, analysts may desire to discount returns to some other economic income measure, such as pretax cash flows, net income, earnings before interest and taxes (EBIT), or earnings before interest, taxes, depreciation, and amortization (EBITDA).

This issue has received considerable attention in recent years. For example, due to the increase in businesses whose entire taxable income is reported as taxable income to the owners (not just the distributions made to the owners), these entities do not report net cash flow as we have defined the term in this book. That income is passed through and taxed directly to the owners and not taxed at the entity level (commonly referred to as pass-through entities). The importance of pass-through entities can be seen by the relative numbers of U.S. income tax returns represented by pass-through entities:

Of the 34 million business tax returns ...