Inflation and the rule-of-thumb method of adjusting discount rates for income taxes
The rule-of-thumb method of adjusting discount rates for income taxes is (after-tax rate) = (before-tax rate) × (1 – tax rate). Previous researchers have concluded that the rule-of-thumb adjustment for income taxes is accurate only when the investment alternative used to define the opportunity cost of capital has certain characteristics: if other investments are limited to land rental, taxable bonds, and bank certificates of deposit, for example. In the present article we demonstrate that inflation is also an important factor in the rule-of-thumb’s accuracy in accounting for income taxes. If the unmodified rule-of-thumb adjustment for income taxes is applied to a discount rate specified in uninflated terms, the estimated discount rate may be significantly higher or lower than the actual rate. If applied to real interest rates and not corrected for the effect of inflation, the rule-of-thumb will overestimate the after-tax discount rate that is equivalent to a specific before-tax rate; it will underestimate the before-tax rate equivalent to an after-tax rate specified in real terms. Discount rates estimated by the unmodified rule-of-thumb applied in real terms can be six percentage points or more too high or too low, depending on the rate of inflation, the income tax rate, and whether a before-tax or an after-tax discount rate is being estimated. We present modified rule-of-thumb formulas to adjust real discount rates for income taxes. They include a correction factor to account for the impact of inflation. We summarize these and other formulas used to adjust discount rates for inflation and income taxes in discounted cash flow analysis.
Bullard, Steven H.; Straka, T. J.; and Caulfield, J. C., "Inflation and the rule-of-thumb method of adjusting discount rates for income taxes" (2001). Faculty Publications. 46.
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