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Pre-Tax Post-Tax Ke d

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KnS Institute of Business Studies Pre-tax / Post-tax Ke and Kd Calculation of E & Ke SH's required return Pre-tax = Company's cost of equity Post-tax When Ke is determined using Dividend valuation model - its company's post-tax Ke CAPM- its shareholders’/investors’ required pre-tax rate - again company's post-tax Ke Accordingly, in CAPM when we use Rm & Rf, these are pre-tax rates Implications for our working For calculating WACC, we require company's post-tax Ke. Accordingly, Ke determined eit
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  KnS   Institute of Business Studies Pre-tax / Post-tax Ke and Kd P repared by Page 1 Sir Khalilullah Shaikh   Calculation of E & Ke  SH's required return Pre-tax = Company's cost of equity Post-tax When Ke is determined using- DCSH Preividend valuation model - its company's post-tax Ke- APM- its shareholders’/investors’ required pre-tax rate - again company's post-tax Ke Accordingly, in CAPM when we use Rm & Rf, these are pre-tax rates  Implications for our working -For calculating WACC, we require company's post-tax Ke. Accordingly, Ke determined either via DividendValuation Model /CAPM, it is directly taken without any further adjustment.-Similarly, if we are given SH's pre-tax required rate, it is taken directly as company's Ke without anyadjustment.-If we are given 'SH's post-tax required rate', then we need to convert it into SH's pre-tax required rate first(using SH's personal tax rate) - in order to use it for WACC and for calculation of E via dividend valuationmodel. e.g. A company has recently paid dividend of Rs 5/share. Profits and dividends of the company are expected togrow @ 6% p.a. on average. Company's shareholders require post-tax return of 12%. Personal tax ofshareholders is estimated to be 20%. Calculate the MV per share of the company.'s post-tax return 12%-tax required return of SHs 15% 12%/(1-20%) This is company's cost of equity Ke  Now, using dividend growth model the MV per share of the company is: D o ( 1 + g )   MV (E) =Ke – g   = 5 ( 1+ 6%)   15% - 6%  E =58.89  KnS   Institute of Business Studies Pre-tax / Post-tax Ke and Kd P repared by Page 2 Sir Khalilullah Shaikh   Calculation of D & Kd  Debt providers (DH's) required return Pre-tax = Company's cost of debt Pre-taxImplications for our working- If we are given 'D' and required to calculate 'Kd' Wainste will plot all future cash flows of the company including tax saving on interest (where taxation is involved) agthe MV. IRR of these cash flows will be required 'post-tax Kd'. Please note that while plotting these cash flows, we assume here that any redemption gain/(loss) - difference between MV and Redemption value of security- is not a taxable item and accordingly no tax impact is calculated on this difference. - If we are given cost of debt/market return on debt and required to calculate 'D' 1) If we are given post-tax cost of debt of the company (post-tax Kd)We will plot all future cash flows including tax on interest (means post-tax cash flows) and discount these cashflows with post-tax Kd. It will give us MV (D) of the debt. Please note that while doing so; we automaticallyassume that any redemption gain/(loss) - difference between MV and Redemption value of security- is not ataxable item e.g. A company has in issue 10% debentures which are redeemable at par after 3 years. If the post tax cost ofthese debentures for the company is currently 9% and corporate tax rate is 30%; calculate the MV (D). 0 1 2 3 For a face value of Rs 100  -------------------- Rs ----------------------Interest 10 10 10Tax @ 30% on interest (3) (3) (3)Redemption at par 100Post tax cash flows 7 7 107Discount using post-tax Kd 9% - PV6.4 5.982.6MV (D) 94.9  KnS   Institute of Business Studies Pre-tax / Post-tax Ke and Kd P repared by Page 3 Sir Khalilullah Shaikh   2)If market rate is given; then this market rate is the DH's pre-tax required return OR pre-tax Kd for companyIn this situation; the MV will be calculated by plotting pre-tax future cash flows of the debt and discountingthem with given pre-tax Kd.The post-tax Kd will be calculated as Post-tax Kd = Pre-tax Kd (1- t%)This will assume that any redemption gain/loss - difference between MV and Redemption value of security- istaxable! e.g. A company has in issue 12% debentures which are redeemable at par after 3 years. The market rate onsecurities of similar credit rating with same tenure to maturity is currently 15%. Corporate tax rate is 30%.Calculate the MV (D) and post-tax cost of debentures for the company. 0 1 2 3 For a face value of Rs 100  -------------------- Rs ----------------------Interest 12 12 12Redemption at par 100Pre- tax cash flows 12 12 112Discount using pre-tax Kd 15% - PV10.4 9.173.6MV (D) 93.15 Post-tax Kd = 15 x (1 - 30%) Post-tax Kd = 10.50%  This post-tax Kd assumes that any redemption gain/loss is also a taxable item.
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