Contents - AL-Tax

9.5 Comparison 135and the value of its debt, D, is $145 million. We assume a combined federal andstate statutory tax rate, t, of 0.40. Therefore, under the required return method, USS’after-tax free cash flows, FCF, are equal to $8.841 million:FCF = r e × E + r d (1 − t) × D (9.1)FCF = 0.0902 × 55 + 0.0446(1 − 0.4) × 145 = 8.841 (9.2)Using the after-tax free cash flows of $8.841 million computed above as a startingpoint, USS’ before-tax net income can be determined as follows: Add the tax shield on debt (0.4 × 0.0446 × $145 million), or $2.587 million. Deduct interest expense of (0.0446 × $145 million), or $6.467 million. Add USS’ actual investment in tangible and intangible assets and changes inworking capital ($15.5 million) and deduct its non-cash charges ($12.8 million). Divide by (1 − t), the statutory tax rate.If USS repaid any principal or borrowed additional monies during the relevantperiod, these amounts should be factored into the analysis. (We assume that it didnot.) USS’ arm’s length before-tax net income, prior to factoring in any firm-specificcarryforwards, credits, etc., is equal to $12.8 million.9.4.5 Adjustments to Reflect Loss Carryforwards,Other Firm-Specific FactorsFinally, it remains to adjust USS’ estimated before-tax net income for any additionaltax-reducing factors. USS has certain loss carryforwards that reduce its taxableincome by $2.5 million. Therefore, under the required return methodology, USSshould report taxable income of $10.3 million.9.5 ComparisonFor the reasons discussed in Chapter 3, the resale price method often has significantshortcomings in terms of the reliability of results (relative to actual arm’s lengthallocations of income). While conceptually more compelling, the required returnmethod necessitates a hefty dose of subjective judgment in practice, absent taxingauthorities’ consensus on certain simplifying conventions regarding the valuation ofequity capital and the use of published industry betas, risk-free rates, market riskpremia and safe harbor loan rates. If this framework is not put in place, the requiredreturn methodology may not significantly enhance the consistency of results acrosstax jurisdictions, and between corporations and individual tax authorities.Moreover, the required return methodology is more labor-intensive than theresale price method. To some degree, this feature can be reduced by mutualagreement on various valuation conventions, but it cannot be entirely eliminated.