The new Tax Cuts and Job Act is expected to have a significant impact on businesses and their valuations over the next several years. Signed into law on December 22, 2017, the tax law includes a lower corporate tax rate, changes to tax credits and deductions for businesses, and a regional tax model for companies with foreign income. This article focuses on how the new tax law impacts businesses and its effect on business valuation.
New Tax Law’s Effect on Businesses
The Act replaced the prior corporate tax rate, which taxed income over $10 million at 35%, with a flat rate of 21%. This will push down the effective tax rate on businesses from 25% towards 21%. Also, small and medium-sized pass-through entities, in which profits are passed directly to business owners, will see a reduction in their effective tax rate.
The new tax law also extended and modified bonus depreciation, allowing businesses to immediately deduct 100% of the cost of eligible property in the year it is placed in service, through 2022. After 2020, the amount of allowable bonus depreciation will be phased down over four years: 80% will be allowed for property placed in service in 2023, 60% in 2024, 40% in 2025, and 20% in 2026.
Another significant change for businesses in the new tax law includes the interest expense deduction limitation. Under the Act, the deduction for business interest is limited to the sum of (1) business interest income; (2) 30% of the taxpayer’s adjusted taxable income for the tax year; and (3) the taxpayer’s floor plan financing interest for the tax year. Any disallowed business interest deduction can be carried forward indefinitely and any taxpayer that meets the $25 million gross-receipts test is exempt from the interest deduction limitation.
Also, to make US companies more competitive and to more closely align with international standards, the new tax law will make taxation more regional by limiting overseas liabilities and encouraging the repatriation of profits held abroad.
Other changes in the new tax law affecting businesses includes the treatment of inventories, net operating losses, like-kind exchanges, domestic production activities, meals and entertainment expenses, qualified transportation fringe benefits, and other business tax credits.
New Tax Law’s Effect on Business Valuations
Business appraisers use three primary approaches to value businesses: the Income, Market, and Asset Approaches. Because each approach measures value differently, the new tax law is expected to uniquely impact each approach. The Income Approach converts expected future cash flows to a present value, while the Market Approach uses actual sales of businesses or market prices to develop indications of value. In the Asset Approach, equity value is estimated by restating the value of assets and liabilities from historical cost to fair market value. The new tax law is expected to have the most significant impact on the inputs used in the Income and Market Approaches, which we discuss below.
In the Income Approach, the amount of future cash flows and the discount rate used to calculate the present value of those future cash flows will be impacted by the new tax law.
The new tax law not only changes the tax rate for a business, but also the calculation of taxable income. Therefore, appraisers will be forced to carefully model and appropriately support the changes in taxable income due to the Act. The key factors to consider include the treatment of capital expenditures and limitations on interest expense deductions, as well as the provisions that will change over time or expire altogether.
To model all of the changes of the new tax law, a discounted cash flow model may be preferred, as opposed to a capitalized cash flow model. Also, it is expected that modeling future cash flows will be challenging in the next year until the impact of the new tax law is more clearly known.
The discount rate, which is applied to the expected cash flows of a business and reflects the perceived risk of achieving those cash flows, is generally calculated by weighting the after-tax cost of debt and the cost of equity, known as the weighted average cost of capital (“WACC”). The impact of the lower tax rate on the WACC is complex, as it affects both the cost of debt and cost of equity.
The reduced tax rate increases the after-tax cost of debt, but the calculation depends on the company’s ability to deduct its interest expense, which may be limited by the Act. Calculating the impact on the cost of equity is more challenging, as several of the inputs, including the estimation of the market equity risk premium and the beta, use historical data and do not yet reflect the new tax law impact. These factors, along with the changes in interest expense deductibility, will likely change the impact of leverage and depending on the facts and circumstances, the WACC using assumptions from the new tax law could either increase or decrease compared to historic levels before the Act.
In the Market Approach, the guideline publicly-traded companies and transaction multiples are affected by the new tax law to varying degrees.
Market multiples of publicly-traded companies increased throughout 2017 in part due to the anticipation of the lower corporate taxes. While the guideline public company method may incorporate the market participant’s expectations regarding value inclusive of the anticipated tax changes, business appraisers should carefully select appropriate guideline public companies, especially when considering the valuation of multinational businesses or companies with high leverage. Since some companies may benefit more than others from the new tax law, even within the same industry, these differences should be considered by the appraiser in the selection of multiples in the Market Approach.
The prices paid for completed transactions may not have reflected the full impact of the new tax law since they reflect pricing over a longer historical period, when the tax changes were uncertain. It is expected that over time, the market transactions and the corresponding multiples will reflect the changes in the new tax law.
All the new corporate tax law changes, including the reduced income tax rate and changes to the treatment of interest deductions and capital expenditures, will need to be considered in future business appraisals and will likely have a significant impact on business value. According to Aswath Damodaran, a professor of finance at the Stern School of Business at New York University, “No matter what you think about the tax reform package, there is the one thing that is not debatable: it will impact equity value and affect corporate behavior in the coming year.”
Paul Heidt, ASA is the Director of Valuation Research for Morones Analytics. He has substantial experience in valuing closely-held businesses.
References for this article include “Congress enacts tax reform,” Alistair M. Nevius, J.D., Journal of Accountancy, February 2018, “January 2018 Data Update 3: Taxing Questions on Value,” Aswath Damodaran, Musings on Markets, January 12, 2018, “Considering the impact of the tax cuts and jobs act on valuations,” Ernst & Young LLP, December 22, 2017, “Valuation Experts Give Initial Thoughts on Tax Reform,” Business Valuation Update, February 2018, and “3 Economic Impacts of the Tax Cuts and Jobs Act,” Jim Glassman, JPMorgan Chase and Co., January 3, 2018.
 “3 Economic Impacts of the Tax Cuts and Jobs Act,” Jim Glassman, JPMorgan Chase & Co., January 3, 2018.
 “Considering the impact of the tax cuts and jobs act on valuations,” Ernst & Young LLP, December 22, 2017.
 “Valuation Experts Give Initial Thoughts on Tax Reform,” Business Valuation Update, February 2018.
 “January 2018 Data Update 3: Taxing Questions on Value,” Aswath Damodaran, Musings on Markets, January 12, 2018.