Question

There is a certain company “A” which has been recording zero taxes in the Income Statement for the past few years. It is estimated that the company will continue to do the same for another year. This implies the company is expected to have zero taxes recorded in the Income Statement for another year and then start recording tax expenses.
Under this scenario , how should we calculate WACC (consider taxes as zero?) which will be used to discount the 10 forecasted years Free Cash Flows and the Terminal value?

Answer 1

In the WACC formula you have cost of equity and cost of debt.
The cost of equity part will not get affected much because it takes the 'net profits after tax' in to account. The cost of debt will have a slight change because the formula takes in to account the effective interest rate multiplied by (1-t) to take the tax factor in to account for adjusting for tax shield. In this case 't' which is the tax rate would be zero. If the rate of borrowing (interest) is 10% the same is taken as cost of debt instead of adjusting it for tax factor.
For choice of discount rate you can take the rate of interest offered by a 10-year government bond or treasury bond plus some risk premium so that the total discount rate is comparable to the expected return on a similar kind of business with similar risk-return profile.

Answer 2

I agree with your treatment for the first year but since this company is expected to record taxes from second year onwards, should'nt we discount the cash flows at different rate?

Answer 3

Yes you have a good point. Assuming the company records taxes from 2nd year, the discount factor from second year onwards would be different. Although this is not a standard practice this can be followed for this case.
If the taxes appear after 3rd year or later then you need to re work on teh cash flow and discounts rates accordingly and explain it to your audience. If you state your assumptions clearly I think you will be on right track. Hope this helps.