Letters

More About CAPM and WACC

I am responding to the letter, “Direct or Indirect—CAPM or WACC?” (JofA, Feb.02, page 13) on “Taking the Temperature of Health Care Valuations” (JofA, Oct.01, page 79).

I agree with the letter writer’s analysis as to the method by which a discounted cash flow (DCF) model is used to arrive at the value of equity and that the discount rate must match with cash flow to equity or invested capital. However, I believe the article overall was correct— perhaps just a little loose with the terminology.

A discount rate can be applied for equity, for debt or the weighted average of both, otherwise known as the weighted average cost of capital (WACC). The article used “discount rate” generically, which apparently caused the letter writer’s concern.

If the equity discount rate component of the WACC is determined from the capital asset pricing model (CAPM), it is fair to say the entire discount rate (WACC) is determined from a “variation” of the CAPM. The article did, in fact, speak of exhibit 1 as illustrating the “final steps” of the DCF method, “subsequent to forecast development, calculation of free cash flows and discount rate determination.” Thus, the example did not purport to show the entire calculation of the discount rate used.

The article also spoke of a valuator’s obtaining a “discount rate” by “using a variation of” CAPM. It seems fair to read that to mean that the equity component of the discount rate was determined from the CAPM while the debt component was not specifically addressed. I think the crux of the issue is that the term discount rate was used rather than “WACC derived in part from CAPM.”

Although unlikely to be apparent to a JofA reader not involved in health care valuation, 16% is a generic WACC for health care transactions. With that in mind, I did not find the article misleading, but it does indicate a need for specificity when the authors use terms with more than one meaning.

Mark O. Dietrich, CPA/ABV
Framingham, Massachusetts

ETFs and Taxes

The article, “A Primer on Exchange-Traded Funds” (JofA, Jan.02, page 38) was a good introduction to these popular investments. However, it didn’t discuss some other tax implications that may arise, especially for those individuals buying and selling often.

For example, wash-sale rules might come into play. If one purchases an exchange-traded fund such as the S&P 500 Spider, sells it at a loss and buys the iShares S&P 500 within 30 days, would this come under the wash-sale rules? The answer is not clear. Many experts disagree, and the Internal Revenue Service has not ruled on this yet. Wash-sale rules could apply when buying HOLDRs, which comprise a basket of preselected stocks in one sector, and can be “cancelled,” allowing an investor the right to sell any of the individual stocks. In addition, capital gains tax may be due if one company in the HOLDR sector buys another in that group.

Although IRS guidance is clearly needed, CPAs must be very knowledgeable about ETFs and inform clients of the tax consequences that may arise from owning these investment vehicles.

Erica Rubin, CPA
J.H. Cohn LLP
New York City

Author’s reply: The letter makes a good point. A CPA needs to know about the wash-sale rules, and what qualifies as “substantially identical” can be confusing. You are allowed to purchase shares in a different company in the same industry or another mutual fund with a similar strategy. The IRS hasn’t specifically weighed in on how index funds or exchange-traded funds are treated under wash-sale rules, and many experts say the agency would disqualify a loss where an investor sold one S&P 500 index fund and bought another.

The bottom line is that an ETF can both open doors and raise new tax issues. In this evolving area, tax practitioners do need to make certain assumptions.

Phyllis Bernstein, CPA/PFS
Phyllis Bernstein Consulting Inc.
New York City