On the Relevance and the Irrelevance of Personal Income Taxes for the Valuation of Equity Investments

Abstract

This paper presents a comprehensive and consistent valuation approach including investor taxes (personal taxes) in addition to corporate taxes. It is shown that personal taxes do not influence the valuation result as long as the expected rate of return of an alternative investment opportunity is used as a discount rate, which is comparable in all relevant dimensions. These dimensions are the growth rates of expected cash flows, the risk associated with this growth profile, and the taxation of these cash flows relative to the taxation of potential capital gains. If, however, the alternative investment opportunity is taxed differently, e.g., by means of different tax rates to be applied or different treatment of capital gains, personal taxes become relevant. The valuation approach then has to account for the relative difference in taxation. It is shown how to modify unlevered cost of equity, cost of debt, and the weighted average cost of capital.

Keywords: Discounted cash flow, risk-adjusted discount rates, tax shield, cost of capital, personal taxes

JEL Classification: G32