Journal of Applied Research in Accounting and Finance
Vol 5 (2) December 2010
Why Pre-Tax Discount Rates Should Be Avoided by Kevin Davis
Lonergan (2009) and Jindra and Voetmann (2010) analyse comparative results from discounting post-tax cash flows at a post-tax discount rate versus discounting pre-tax cash flows at a pre-tax discount rate. While their results are correct within the context of their analysed examples, these examples do not include the most common and interesting problems which financial managers will face. This paper demonstrates that there is no simple standard adjustment which can be made to available post-tax discount rates to enable analysis of pre-tax cash flows in the general case. The problem is even more stark when valuation is attempted on a real pre-tax basis, as had been applied in a number regulatory access pricing situations.
Pre and Post-Tax Discount Rates by Martin Hall
Lonergan (2009) expounded that a proper valuation of equity or business cash flows should use post-tax cash flows discounted at a suitable post-tax discount rate. The use of pre-tax cash flows discounted at a pre-tax discount rate is not only fraught with difficulty, it is in some instances erroneous. This article examines the argument by Lonergan, and subsequent discussions by Jindra & Voetmann (2010) and Davis (2010). It concludes that discounting post-tax cash flows at post-tax discount rates is a sensible valuation approach for these assets, as it can be appropriately calibrated, whereas pre-tax discount rates cannot.
The Problem of Pre-Tax Valuations: A Note by Michael Dempsey, Michael McKenzie and Graham Partington
This paper highlights the problems in valuation that are inherent in the use of the pre-tax cost of capital and in other tax adjustments to the discount rate. The source of problems in relation to the pre-tax discount rate is clarified and examples are given to highlight the nature of the problems. Finally, a solution is provided that overcomes these problems. However, it is recommended that pre-tax valuations are best avoided.
Some Rates are Better than Others by Kaiying Ji
Within the growing literature on goodwill impairment testing under the IFRS framework, the topic of discount rate selection choice by reporting entities has been particularly controversial. Some previous researchers, notably Carlin & Finch (2009) have argued that there is credible evidence to sustain the proposition that a non-trivial number of firms reporting under IFRS have applied indefensibly low discount rates when testing for impairment. Other scholars (for example, Gallery, 2009) have suggested that an insufficient quantity of evidence has accumulated to this point to sustain such a proposition with adequate confidence. This paper contributes to the literature by reviewing an extended data set on discount rate selection choice by ASX-listed firms. It concludes that the incidence of the application of unusual or 'out of expectations' discount rates is a continued and persistent feature of the Australian financial reporting landscape and that for a significant number of firms, variations between expected and actual applied discount rates remain material.