Question

Marginal vs effective rate question:
for the non constant growth phase when I want to use the effective tax rate to tax my NOPAT can I use the effective tax rate to compute the after tax cost of debt and the bottom up levered beta? I feel inconsistent to tax the cash flow using effective and to tax the cost of debt and D/E ratio in beta levered using the marginal.

Answer 1

Nothing inconsistent about it, since they measure different things. The tax rate you use to compute cash flow applies to all of your income, and hence we use the effective tax rate. The tax rate used to compute the after tax cost of debt and levered beta reflect the tax savings from interest expenses, which occur at the margin. Hence, we use the marginal tax rate.

Answer 2

Thanks but I am a non US citizen. Why would the interest tax savings be based on the marginal,which I assume is the tax on each additional dollar of taxable income. The idea is blurry
Thanks again and I hope it is not a naive question