KnS Institute of Business Studies

Pre-tax / Post-tax Ke and Kd

Calculation of E & Ke

SH's required return Pre-tax = Company's cost of equity Post-tax

When Ke is determined using

- Dividend valuation model - its company's post-tax Ke
- CAPM- its shareholders’/investors’ required pre-tax rate - again company's post-tax Ke
Accordingly, in CAPM when we use Rm & Rf, these are pre-tax rates

Implications for our working

For calculating WACC, we require company's post-tax Ke. Accordingly, Ke determined either via Dividend
-
Valuation Model /CAPM, it is directly taken without any further adjustment.
Similarly, if we are given SH's pre-tax required rate, it is taken directly as company's Ke without any
-
adjustment.
If we are given 'SH's post-tax required rate', then we need to convert it into SH's pre-tax required rate first
- (using SH's personal tax rate) - in order to use it for WACC and for calculation of E via dividend valuation
model.
e.g.
A company has recently paid dividend of Rs 5/share. Profits and dividends of the company are expected to
grow @ 6% p.a. on average. Company's shareholders require post-tax return of 12%. Personal tax of
shareholders is estimated to be 20%. Calculate the MV per share of the company.

SH's post-tax return 12%

Pre-tax required return of SHs 15% 12%/(1-20%) This is company's cost of equity Ke

Now, using dividend growth model the MV per share of the company is:

MV (E) = Do( 1 + g )
Ke – g

= 5 ( 1+ 6%)
15% - 6%

E = 58.89

Prepared by
Page 1 Sir Khalilullah Shaikh
KnS Institute of Business Studies
Pre-tax / Post-tax Ke and Kd

Calculation of D & Kd

Debt providers (DH's) required return Pre-tax = Company's cost of debt Pre-tax

Implications for our working

- If we are given 'D' and required to calculate 'Kd'

We will plot all future cash flows of the company including tax saving on interest (where taxation is involved) against
the MV. IRR of these cash flows will be required 'post-tax Kd'.
Please note that while plotting these cash flows, we assume here that any redemption gain/(loss) - difference
between MV and Redemption value of security- is not a taxable item and accordingly no tax impact is calculated on
this difference.

- If we are given cost of debt/market return on debt and required to calculate 'D'

1) If we are given post-tax cost of debt of the company (post-tax Kd)

We will plot all future cash flows including tax on interest (means post-tax cash flows) and discount these cash
flows with post-tax Kd. It will give us MV (D) of the debt. Please note that while doing so; we automatically
assume that any redemption gain/(loss) - difference between MV and Redemption value of security- is not a
taxable item

e.g.
A company has in issue 10% debentures which are redeemable at par after 3 years. If the post tax cost of
these debentures for the company is currently 9% and corporate tax rate is 30%; calculate the MV (D).

0 1 2 3
For a face value of Rs 100 -------------------- Rs ----------------------

Interest 10 10 10

Tax @ 30% on interest (3) (3) (3)

Redemption at par 100

Post tax cash flows 7 7 107

Discount using post-tax Kd 9% - PV 6.4 5.9 82.6

MV (D) 94.9

Prepared by
Page 2 Sir Khalilullah Shaikh
KnS Institute of Business Studies
Pre-tax / Post-tax Ke and Kd

2) If market rate is given; then this market rate is the DH's pre-tax required return OR pre-tax Kd for company

In this situation; the MV will be calculated by plotting pre-tax future cash flows of the debt and discounting
them with given pre-tax Kd.
The post-tax Kd will be calculated as Post-tax Kd = Pre-tax Kd (1- t%)
This will assume that any redemption gain/loss - difference between MV and Redemption value of security- is
taxable!

e.g.
A company has in issue 12% debentures which are redeemable at par after 3 years. The market rate on
securities of similar credit rating with same tenure to maturity is currently 15%. Corporate tax rate is 30%.
Calculate the MV (D) and post-tax cost of debentures for the company.

0 1 2 3
For a face value of Rs 100 -------------------- Rs ----------------------

Interest 12 12 12
Redemption at par 100

Pre- tax cash flows 12 12 112

Discount using pre-tax Kd 15% - PV 10.4 9.1 73.6

MV (D) 93.15

Post-tax Kd = 15 x (1 - 30%)

Post-tax Kd = 10.50%

This post-tax Kd assumes that any redemption gain/loss is also a taxable item.

Prepared by
Page 3 Sir Khalilullah Shaikh