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  1. 028A company's tax rate rises from 25% to 30%. Name three ways this moves a DCF and put numbers on each for a business with EBIT of Rs 200 crore, funded 30% by debt at 8% before tax and 70% by equity at 12%.DCF and cost of capitalHardGoldman SachsSan Francisco · 2025

    Try it first

    Which way does the valuation move overall?

    Show the worked solution

    The value falls, by about 4.8% here, because the cut to cash flow outweighs the cheaper debt. One: unlevered free cash flow falls, as NOPAT drops from Rs 150 crore to Rs 140 crore. Two: the after-tax cost of debt falls from 6.0% to 5.6%, taking the WACC from 10.20% to 10.08%. Three: the terminal value, which carries both effects, falls from about Rs 2,516 crore to Rs 2,395 crore at 4% growth.

    Why does a tax rate touch both the top and the bottom of the fraction?

    A landlord pays more tax on her rent, so the rent she keeps falls; but the interest on her mortgage is deductible, so the loan costs her a little less after tax. Two opposite effects from one change. A DCF is the same fraction: cash flow on top, discount rate below. A higher tax rate shrinks the cash flows directly and shrinks the WACC indirectly through the interest tax shield, and the first effect is almost always larger because it hits every rupee of operating profit while the second touches only the debt slice. Interviewers ask for three ways so that you show both sides and then say which wins.

    One tax rate, three doors into the DCF: the cash flow door is the wide oneTax rate25% to 30%1. Free cash flow, every yearNOPAT = EBIT x (1 - t): Rs 150 to Rs 140 croredown Rs 10 crore, 6.7%2. Cost of debt, then WACC8% x (1 - t): 6.0% to 5.6%WACC 10.20% to 10.08%, down 12 bp3. Terminal value, 4% growthNOPAT x 1.04 / (WACC - 4%): 2,516 to 2,395 croredown Rs 121 crore, 4.8%Terminal value change, Rs crore-168cash flow+46WACC-121net-4.8%cash flow effect alone,then the WACC reliefWhy the cash flow door is wider: tax hits every rupee of EBIT, while the WACC relief touches only the 30% debt slice.
    The tax rise cuts NOPAT from Rs 150 crore to Rs 140 crore, lowers the WACC from 10.20% to 10.08% through the cheaper after-tax debt, and takes the terminal value from Rs 2,516 crore to Rs 2,395 crore, because the cash flow effect of Rs -168 crore outweighs the WACC relief of Rs 46 crore.

    How big is each effect on these numbers?

    Cash flow. NOPAT is EBIT times one minus the tax rate: Rs 200 crore x 0.75 = Rs 150 crore before and Rs 200 crore x 0.70 = Rs 140 crore after, a fall of Rs 10 crore, or 6.7%, in every forecast year, treating depreciation, capex and working capital as cancelling out. Discount rate. The after-tax cost of debt is 8% x (1 - t): 6.0% before and 5.6% after. Weighted at 30% debt and 70% equity at 12%, the WACC moves from 10.20% to 10.08%, down 12 basis points. Terminal value. At 4% growth, a Gordon growthA terminal value that treats the final cash flow as growing at a constant rate forever: the next cash flow divided by the discount rate less the growth rate. terminal value is Rs 2,516 crore before and Rs 2,395 crore after. Separating the two, the cash flow cut alone takes Rs 168 crore off the terminal value and the lower WACC alone adds Rs 46 crore back, so the net is Rs 121 crore, 4.8% lower.

    LineTax 25%Tax 30%Change
    NOPAT, Rs crore150140-6.7%
    After-tax cost of debt6.0%5.6%-40 bp
    WACC10.20%10.08%-12 bp
    Terminal value at 4% growth, Rs crore2,5162,395-4.8%
    Illustrative inputs from the question: EBIT Rs 200 crore, 30% debt at 8%, 70% equity at 12%, long-run growth 4%.
    The relationship
    WACC=0.30×8% (1−t)+0.70×12%TV=EBIT (1−t) (1+g)WACC−gWACC = 0.30 \times 8\%\,(1-t) + 0.70 \times 12\% \qquad TV = \frac{EBIT\,(1-t)\,(1+g)}{WACC - g}
    (1 - t)the share of each rupee left after tax, 0.75 falling to 0.70
    0.30, 0.70the debt and equity weights
    gthe long-run growth rate, 4% here
    What it says in wordsThe tax rate enters the cash flow once and the discount rate once, and the cash flow effect is the larger of the two.

    Is there a subtler channel the interviewer might be after?

    Yes: the cost of equity. When you relever a beta, the formula carries a (1 - t) term, so a higher tax rate lowers the levered beta a little and the cost of equity with it. With debt to equity of 3 to 7 and a levered beta of 1.0 at 25%, the unlevered beta is 0.757, and relevering at 30% gives 0.984; with an assumed 6% risk-free rate and 6% equity risk premium, the cost of equity slips from 12% to 11.90% and the WACC to 10.01%. Even with that help the value is still about 3.7% lower, so the ranking of the effects does not change. Say the limitation too: the WACC relief assumes the company actually pays tax and keeps its interest deductible, and interest deductions are capped in many jurisdictions, a rule to confirm for the country in question.

    Where candidates lose it

    The common loss is naming only the cash flow effect, or naming the WACC effect and then concluding that value rises. Three ways means cash flow, the cost of debt inside the WACC, and the terminal value or cost of equity that carries them, and the net is down.

    The second loss is putting no numbers on it. The question hands you EBIT, weights and rates so that you can say Rs 150 to Rs 140 crore and 10.20% to 10.08% out loud; a candidate who stays qualitative has not answered.

    What the interviewer asks next

    • If the company had no debt at all, which of the three effects survive?
    • How would a large tax-loss carryforward change the answer?
    • Why might a biotech DCF, with years of losses ahead, be almost indifferent to this change?

    Asked at Goldman Sachs, Investment Banking, San Francisco, 2025 (Wall Street Oasis): Three ways in which the tax rate affects a DCF?

  2. 085A software company's free cash flow is Rs 130 crore if Rs 30 crore of stock-based compensation is added back as a non-cash charge, and Rs 100 crore if it is treated as a cash cost. With a WACC of 10% and perpetual growth of 3%, how far apart are the two perpetuity values, and which treatment is right?DCF and cost of capitalHardLazardNew York · 2026

    Try it first

    Which treatment gives the right value for today's shareholders?

    Show the worked solution

    About Rs 441 crore apart: Rs 1,913 crore with the add-back against Rs 1,471 crore without, a 30% gap. Treat the compensation as a real cost. It is paid in shares rather than cash, but existing holders bear it through dilution. Either deduct it from cash flow and use today's diluted share count, or add it back and count every future share it will create. Adding it back and ignoring the dilution counts the cost as zero.

    If no cash leaves, why is stock compensation a cost?

    Imagine a family business that pays its manager not in salary but by handing over a slice of the shop every year. No cash leaves the till, but each year the family owns less of the shop. Stock compensation is a real expense paid in ownership instead of money, and today's shareholders pay it through dilution. If the company had paid staff Rs 30 crore in cash, everyone would deduct it. Paying in shares changes who bears the cost, not whether there is one.

    The two values follow from the perpetuity formula. With the add-back, 130 x 1.03 / (10% - 3%) is about Rs 1,913 crore. Treated as a cost, 100 x 1.03 / 7% is about Rs 1,471 crore. The gap, about Rs 441 crore, is exactly the present value of paying Rs 30 crore a year, growing at 3%, in shares.

    The gap is the value of the shares you are quietly giving away1,913SBC added back1,471SBC as a cost-441gap = 30 x 1.03 / 7% = 44130% of the lower valueConsistentDeduct SBC as a cost, usetoday's diluted share countConsistentAdd SBC back, then count everyfuture share it will issueWrongAdd SBC back and ignore thedilution: counts the cost as zeroValues are perpetuities, Rs crore: next year's cash flow over (10% - 3%).
    Adding back Rs 30 crore of stock compensation lifts the perpetuity value from Rs 1,471 crore to Rs 1,913 crore, and the Rs 441 crore gap is the present value of the shares handed to staff, so it must be deducted or counted as dilution.

    Can the add-back version ever be right?

    Yes, if you finish the job. Add the Rs 30 crore back, value the firm at Rs 1,913 crore, then recognise that the company will issue Rs 30 crore of new shares every year, growing at 3%, forever. Those future holders own a stream worth Rs 441 crore of the total, leaving Rs 1,471 crore for today's shareholders. Both consistent methods land on the same value for existing holders; the error is adding back the expense and then dividing by today's share count, which counts the cost nowhere. In practice, deducting it is simpler, because projecting every future grant into the share count is hard.

    The relationship
    Vadd−Vded=SBC×(1+g)r−g=30×1.030.07≈441V_{\text{add}} - V_{\text{ded}} = \frac{\text{SBC} \times (1+g)}{r - g} = \frac{30 \times 1.03}{0.07} \approx 441
    SBCstock-based compensation, Rs 30 crore a year
    rWACC, 10%
    gperpetual growth, 3%
    What it says in wordsThe difference between the two values is the present value of paying staff in shares forever.

    One honest limitation: existing options and restricted shares already granted are a separate matter, counted in today's diluted share count by the treasury method. The question here is future grants, which the cash flow treatment decides.

    Where candidates lose it

    The standard slip is saying stock compensation is non-cash, so it is added back like depreciation, and stopping there. Depreciation is the echo of cash already spent; stock compensation is a cost paid now, in a different currency.

    The second loss is saying deduct it without being able to explain why the add-back can be made consistent. Name both consistent routes and the one wrong one: that is the answer an associate-level interviewer is looking for.

    What the interviewer asks next

    • How do already-granted options enter the valuation?
    • If the company buys back shares each year to offset dilution, how does that change the cash flow treatment?
    • Why do many sell-side models still add stock compensation back?

    Asked at Lazard, Investment Banking, New York, 2026 (Wall Street Oasis): SBC treatment in DCF