Tax Reform and Value: What business owners need to know.
Is your business worth more – or less – in 2018?
Now that the Tax Cut and Jobs Act is law, what now? Because these rules affect the value of your business, every business owner needs to be aware of these important changes.
Overall, companies with currently high effective tax rates, low leverage, limited tax attributes and high capital intensity are likely winners in the new world. Take away any of these characteristics and the picture is less clear.
Tax Reform Impacts
Impact on cash flows
Many are wondering if the drop in the tax rate from 35% to 21% will increase after-tax income proportionately. In order to determine the full impact on after-tax income, it’s important to remember that the effective federal corporate tax rate averaged 23% in 2017, implying a much smaller decline in the tax rate than what appears on the surface. As such, after-tax earnings are anticipated to increase closer to 7% in 2018 as opposed by more than 20% as implied by the change in the statutory rate from 35% to 21%.
Over time, the ability to fully expense capital expenditures could lead buyers to pay more for assets or businesses. Also, the limits on the deductibility of interest expense could also offset the impact of lower tax rates on free cash flows.
Impact on rate of return
The rules also affect a business’s value through the cost of capital and anticipating effects on the market equity risk premium. A lower tax rate environment may drive more competitive markets. Potential buyers may think expected profits are riskier or less certain due to the new rates. That additional risk may require an increased rate of return to partially offset the gains.
Companies’ cost of debt is impacted in two ways. First, reducing the marginal tax rate increases a company’s after-tax cost of debt. Second, limits on the amount of interest that a company may deduct from taxable earnings further increase the cost of debt, particularly for those companies that are more heavily leveraged.
As the cost of debt and equity capital increases, the value of a company decreases. Potential increases in company value due to improved cash flows may be offset by increases in the cost of capital.
Impact on multiples
In a market-based approach to valuation, the current increase in share prices may already echo the expected changes in tax rate. However, to truly understand the impact on value, it is important to apply forward-looking multiples that reflect a company’s earnings under the new tax law.
In the current environment where there are fewer acquisition targets than buyers, M&A transaction multiples could expand. Corporates that experience lower effective tax rates and repatriate more than $2 trillion in cash held offshore will have more cash to spend on M&A. There are varying data points that suggest that the changes in the tax law will sustain the incredible run seen in transactions with valuations increasing another 0.5x EBITDA.
“No matter what you think about the tax reform package, there is one thing that is not debatable: it will impact equity value and affect corporate behavior in the coming year.” ~Aswath Damodaran, Professor of Finance at the Stern School of Business at NY
Your company’s value is based on many factors, including the company’s assets and its market value. The ability to depreciate equipment faster and the potentially lower tax burdens change the value of your business. Due to the sunsetting of certain provisions such as interest expense deductibility and the expensing of certain qualified capital expenditures, the impact on earnings going forward will be quite varied. Don’t be surprised if longer-term forecasts are requested in order for the impact of the tax changes to be fully reflected in your business value. It’s time to evaluate your company’s new value. Plan now for a more profitable 2018.
Have questions about how the new tax laws affect the value of your business? Quist Valuation can help. Let’s set a time for a free 30-minute consultation. We can discuss the specifics of your business and identify the next steps needed to assess the value of your company.
Schedule your free 30-minute consultation here.