3.3. TAX EFFECT

To compute the after-tax operating income, we multiply the earnings before interest and taxes by an estimated tax rate. This simple procedure can be complicated by three issues that often arise in valuation. The first is the wide differences we observe between effective and marginal tax rates for these firms and the choice we face between the two in valuation. The second issue arises usually with younger firms and is caused by the large losses they often report, leading to net operating losses that are carried forward and can save taxes in future years. The third issue arises from the capitalizing of research and development and other expenses. The fact that these expenditures can be expensed immediately leads to much higher tax benefits for the firm.

3.3.1. Effective versus Marginal Tax Rate

We are faced with a choice of several different tax rates. The most widely reported tax rate in financial statements is the effective tax rate, which is computed from the reported income in the financial statements.

The taxable income is usually before extraordinary items and goodwill amortization.

The second choice on tax rates is the marginal tax rate, which is the tax rate the firm faces on its last (or next) dollar of income. This rate depends on the tax code and reflects what firms have to pay as taxes on their marginal income. In the United States, for instance, the ...

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