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    • br Developing a model for Brazil

    2018-10-23


    Developing a model for Brazil In this section, we use the King and Fullerton methodology to find the expressions for the real required pre-tax rate of return “p” on Brazilian domestic investment, the post-tax rate of return on investment “s”, effective tax rates and the tax wedges as differences between “p” and “s”, by definition. We derive these variables for different types of assets, i.e. machinery, buildings and inventories; and different sources of corporations’ funds, i.e. debt, new equity and retained earnings. An approximation for the equilibrium post-tax rate of return “s” is simply to make it Torin1 cost equal to the nominal interest rates “i”. Now suppose there is tax on interest which is retained at source. If the investor could buy bonds, as said, then she would have to pay the tax. This means that the opportunity cost to invest in the company would require a lower post-tax rate of return than that without the tax. Hence, the after-tax rate of return on investment should be the market interest rate reduced by the tax, thus: Where ω is the tax rate on interest retained at source. Besides taxes, a rational investor would look at the real interest rate and take inflation into account. Where π is the inflation rate. In order to compare King and Fullerton (1984) and in order to compare financial alternatives, we assume that all investments have the same after-tax rate of return. Differences should appear when computing the pre-tax rates of return p for different assets and sources of finance. For a given after-tax rate of return on investment, taxes will probably raise the need for capital and the required pre-tax rate of return on investment will likely rise. However, the lower the pre-tax rate of return on investment, the better for the investor. Therefore, an investor should look at the required pre-tax rate of return on investment p, which is usually higher than s, in order to check if the investment is worthwhile. The pre-tax rate of return on investment is also called the cost of capital. The King and Fullerton model takes the cost of capital as a function of the real interest rate r, and assumes that the required pre-tax rate of return is given by a function c(r). The real interest rate here is an exogenous variable. As mentioned, to compare investment projects we suppose all projects should have the same after-tax rate of return s. Consider an investment project with just one dollar of initial cost. In this situation, for a certain type of asset, the cost of capital will be given by the marginal rate of return (MRR) less the economic depreciation rate for that asset (δ). Thus: Given our one dollar initial cost, thus, the cost of capital of that project is one minus its present discounted depreciation allowances (A): Brazil has only the straight line (L) method. The expression for A is: Where n is the number of years for which a depreciation allowance can be claimed and δth is the statutory depreciation rate. Remember ρ is the company discount rate and depends on the type of financing. Consider V as a sum of all marginal rates of return (MRR) obtained with the asset during a given period of time. The discount factor shall encompass not only depreciation rates but also the inflation rate (assumed constant over time), which increases depreciation, and also the rate at which the company discount cash flows (ρ). Where τ is the (constant) tax rate. The integral above can be computed from time zero to infinity, given: For investment to be attractive, we need that the return of the project (V) would be at least equal to its cost (C). Using Eq. (3) and replacing V by (1−A): Returning to expression (2) we find the pre-tax marginal rate of return as: The previous expression is adequate to derive the cost of capital for investments in machines and buildings. For inventories evaluated with FIFO, the only method allowed in Brazil, there must be a correction for the effects of inflation. Remember that inventories are accounted for their acquisition values and suffer no depreciation. For this case, we get: