A DCF needs cash flows, but substituting a reported cash-tax rate mechanically can create errors. First determine what the taxes relate to, whether financing effects are included, and whether the difference from tax expense is temporary or recurring.
Build a bridge with stated assumptions
Use a fictional unlevered business with operating profit of $100, book tax expense of $25, depreciation of $10, capital expenditure of $15 and a $5 increase in operating working capital. Assume the entire $10 difference between book taxes and cash taxes comes from a temporary operating tax timing difference. No interest, acquisitions or non-operating tax items are present.
| Step | Book-tax starting point | Cash-tax starting point |
|---|---|---|
| Operating profit | 100 | 100 |
| Subtract taxes | (25) | (15) |
| Add depreciation | 10 | 10 |
| Subtract capex | (15) | (15) |
| Subtract working-capital increase | (5) | (5) |
| Add specified tax timing adjustment | 10 | 0 |
| Free cash flow | 75 | 75 |
Both routes reach $75. Using cash taxes of $15 and adding the $10 timing difference again would incorrectly produce $85.
Make the reversal visible
Suppose in year two book tax expense is again $25 but cash taxes are $35 because the same timing difference reverses, with all other inputs unchanged. Cash-tax free cash flow is 100 − 35 + 10 − 15 − 5 = 55. From the book-tax starting point of $65, subtract the $10 reversal to get the same result.
This example does not say every book-to-cash difference reverses next year. It isolates one assumed difference so you can see the mechanics. Real tax bridges may contain permanent differences, refunds, credits, loss carryforwards and prior-period settlements.
Ask three questions before selecting a rate
- What is the denominator? Cash paid divided by pretax accounting income is not automatically a usable tax rate on operating profit.
- Whose cash flows are being valued? An unlevered model must avoid importing an interest tax benefit already reflected through financing assumptions.
- What happens in the terminal period? A temporary low-tax period should not silently become a perpetual assumption.
Damodaran’s valuation questions provide context on tax assumptions in cash-flow valuation. Actual treatment depends on the business and jurisdiction; the figures here are teaching assumptions, not current statutory rates or tax advice.
Use the DCF preparation guide to place this bridge in the full model, then run the terminal-value cross-check. If your tax treatment materially changes terminal value, explain why the benefit is sustainable before presenting the valuation.