Key insights
- The article discusses the appropriate discount rate for projects undertaken by taxable versus non-taxable entities, considering scenarios where WACC, equity ROR, or NPV are equalized. While relevant to corporate finance, it lacks direct, immediate implications for broad US equity market movements.
I have been wondering how and why discount rates should change if the same project is undertaken by a (1) taxable company and a (2) nontaxable company (usually a government entity). There are many such examples in the power sector these days, so the situation is real. The project's risk profile and before-tax cashflow are the same, no matter who undertakes it. The difference in cashflow are: taxable investor pays taxes and takes deductions for depreciation and interest paid. Nontaxable investor does not pay taxes. Assuming borrowing rates are the same for both and both use the same capital structure, there are three ways to think about this:
- The costs of debt and the equity rate of return (ROR) for both entities are the same 1. WACC for the two are different; AT-WACC applies to the taxable entity whereas BT-WACC applies to the taxable entity. 2. NPV for the two are different because both the WACC and the cashflows are different. 2. The costs of debt for both entities are the same. The nontaxable entity has a lower equity ROR such that WACC for both are the same. 1. Equity RORs are different. 2. NPV for the two are different because the cashflows are different. 3. The costs of debt for both entities are the same. The nontaxable entity has higher equity RoR. 1. The equity RoR is solved for making the NPV the same for both. 2. NPV for the two are the same because the equity RoR has been adjusted higher.
Each of the scenarios has some logic to it, but only one has to be correct. Which one is correct?