Comment, question or quotation of the day

21-01-2022 : Question from a reader


Is the net present value of an investment project the same if you discount its pre-tax free cashflows at a pre-tax rate or if you discount its post-tax free cashflows at a post-tax rate?

Generally speaking, one should not confuse the concept and the method of calculation. All too often, we retain the latter, and then the method of calculation makes us forget the concept, which sometimes results in increasingly complicated calculations that are arithmetically correct but disconnected from a simple financial reality that has been lost sight of. 

So let's get back to the basics. The net present value measures the value creation that an investment should allow. The net present value naturally exists before its measurement. In the same way that a patient's temperature pre-exists when measured by a thermometer that is inserted in his or her mouth.

There are two ways to calculate this value creation. One can take a rate after corporate income tax and apply it to free cashflows after corporate tax to be consistent. But we can also take a pre-tax rate and apply it to pre-tax free cashflows. But whatever the calculation, this value creation cannot be rationally different, unless you think that the measurement modifies the object to be measured, which can happen in the field of physics, but it is difficult to see why in terms of value creation.

Thus, when you weigh yourself on a scale calibrated with kilos, your weight is the same as when you weigh yourself on a scale calibrated with pounds, the figure is simply different with a different unit.

Simply the pre-tax rate will be a higher rate than the post-tax rate, see last week's brainstorming where we saw on an illustrative example that a pre-tax rate of 8% corresponded to a post-tax rate of 3.32% for an investment limited to 10 years. In fact, a pre-tax rate is necessarily higher because it will have to remunerate the taxman in part, which was set aside when deciding to reason on pre-tax cashflows. This is why the discounting of pre-tax cashflows with a pre-tax rate is relatively rare, even if it is not stupid. And we could see that there was a correspondence between these two rates which we established thanks to the uniqueness of the net present value, whatever the approach, before or after tax, that we took to compute it.

 

Have a nice day.

19-01-2022 : Quote of the day.


"The direction and magnitude of the bias in your valuation is directly proportional to who pays you and how much you are paid. » Aswath Damodaran, professor of finance at NYU Stern School of Business, specialist of valuation issues



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The Vernimmen.com Letter

Number 140 of December 2021

News : What should we think about the ratio of corporate debt to GDP?

Statistics : Sustainable and green lending in the first half of 2021

Research : Investment options and undervaluation

Q&A : Some brainstorming problems to end the year well

COMMENTS : Comments posted on Facebook