Which tax rate is preferred for long-term forecasting in DCF models?

In the context of Discounted Cash Flow (DCF) models, the marginal tax rate is preferred for long-term forecasting because it represents the tax rate that applies to the next dollar of income earned. Using the marginal tax rate provides a more accurate assessment of the company's future tax liabilities based on expected growth and profit generation. This is particularly important for projecting cash flows, as the marginal rate reflects the current tax implications of additional income rather than the average tax burden over past periods.

In contrast, the effective tax rate, while useful in calculating current overall tax obligations, can be influenced by various deductions and credits that may not be applicable to future projections. The historical tax rate relates to past performance and may not accurately reflect current tax policies. The average tax rate could also misrepresent future liabilities, especially in situations where tax structures change or if the business anticipates significant income growth that could push it into a higher tax bracket. Therefore, the marginal tax rate aligns best with the objective of forecasting future cash flows in a DCF analysis.