Discussion of Valuation of a Firm with a Tax Loss Carryover

Abstract

De Waegenaere et al. (2003) examine the properties of the market-to-book ratio of deferred tax assets arising from tax loss carryovers. The numerator of this ratio reflects the net present value of future cash flows attributable to the deferred tax asset, while the denominator reflects an undiscounted book value. Lack of discounting in the denominator suggests that the market-to-book ratio would be between 0 and 1. However, prior empirical results report market-to-book ratios greater than 1. This paper attempts to provide a theoretical explanation of conditions under which market-to-book ratios might be greater than 1. The paper has two important strengths that broaden its audience appeal. First, its consideration of deferred tax assets focuses on the interface between tax and financial accounting. Second, it attempts to provide theory that explains puzzling empirical results and motivates future empirical testing to validate its predictions. However, the link between any theoretical model and empirical observation focuses attention on the underlying assumptions of the model. This discussion examines several assumptions of this model that may render it inappropriate to the empirical setting it attempts to explain. DEFINING THE VALUATION ALLOWANCE As defined in the paper, the market-to-book ratio of the tax loss carryforward is: