On 20 December 2017, the US House and Senate passed the tax reform bill commonly referred to as the Tax Cuts and Jobs Act (the Act), and it was signed into law by President Donald Trump on 22 December 2017. The sweeping modifications to the US Internal Revenue Code include a much lower corporate tax rate, changes to credits and deductions for both businesses and individuals, and a move to a territorial system for corporations that have overseas earnings.
We expect that buyers will need time to fully assess the impact of the Act. Investors appear to view the changes positively, and major stock exchanges have reached record high valuations, in part due to the anticipated tax changes.
“Many of the changes will influence multinationals in complex ways, and certain provisions of the Act may change over time or expire altogether.“
Nevertheless, some market participants have taken a wait-and-see approach and have not incorporated the expected tax changes explicitly into their deal models. The longer-term impact on individual companies will likely take time to assess given the complexity of the Act, likelihood of future changes to the Act and potential adjustment to operating models implemented by management teams in response to it.
The basic approach to measuring value from a market participant perspective in an orderly transaction has not changed. Therefore, assessing the impact of the tax law change requires consideration of the factors that market participants would evaluate when making transactions in an asset.
It would not be appropriate to use a simplified approach by only changing the tax rate used and assuming that other inputs remain constant. Similarly, it would not be appropriate to selectively include the impact of the Act on parts of the analysis, such as the after-tax cash flows, but not in others, such as the cost of capital.
Due to the complexity of the changes, it is important to consider all the implications when updating variation analyses. Ultimately, the many impacts of the Act on each company will continue to depend on individual facts and circumstances.
Considerations of the impact of the Act on the income approach
The valuation of an asset using the income approach is based on the income-producing capability of the asset and a risk-adjusted discount rate used to calculate the present value of those future cash flows. For valuing a business, both elements are impacted by the corporate tax rate to varying degrees. Therefore, it is important to carefully analyze the impact of the tax rate in the analysis.
- Cash flows: the Act changes not only the tax rate, but also the calculation of taxable income. For this reason, it will be important to carefully model and appropriately support the changes in taxable income due to the Act. Simply calculating a normalized tax rate on reported US generally accepted accounting principles earnings would most likely miss a number of additional impacts created by the Act.
Key factors to consider include changes such as the treatment of capital expenses, limitations on the tax deductibility of interest expense, and differences in amortization for US-based vs. non-US-based research and development costs. We expect valuation analysts to develop more complex models to derive the appropriate taxable income and related taxes to be paid accordingly. Similarly, a careful consideration of those assumptions in the future should be made and the reasoning appropriately supported and documented.
- Discount rate: the discount rate applied to the expected cash flows to be generated by a business reflects the perceived risk of achieving those cash flows. It is generally calculated by weighting the after-tax cost of debt and the cost of equity by the proportions of each component in the actual or potential capital structure of the company.
The impact of a reduced tax rate on this calculated weighed average cost of capital (WACC) is complex, as it affects both the cost of equity and the cost of debt in different ways. The calculation depends on the ability of business to deduct its interest expense, which will be limited by the Act. Risks associated with the likelihood of achieving tax savings through the tax reform could influence the WACC.
Depending on facts and circumstances, the WACC using assumptions from the new Act could either increase or decrease compared with historic levels before the Act. The most important factor will be the company’s leverage.
- Terminal value: some of the Act’s tax cuts and provisions are temporary, with the intent to boost economic growth in the short to medium term. As a result, care should be taken when making assumptions to estimate the business value in perpetuity when using an income capitalization model or an exit multiple.
Considerations of the impact on the market approach
The valuation of a business using the market approach focuses on comparing the target to selected, reasonably similar (or guideline) publicly traded companies or prices paid in recent transactions in the company’s industry or related industries. Both the guideline public company and transaction multiples are affected by the corporate tax rate to varying degrees.
The observed increase in stock market valuations reflects the expected changes in tax rates, as well as companies’ strong performance and growth expectations. Even though the tax rate for most companies is expected to drop, benefits and detriments of the tax reform to each company depend on individual facts and circumstances.
The stock market has increased in part due to anticipation of lower corporate taxes, which is reflected in the higher observed multiples. However, completed transactions may not have reflected the full impact of the Act since they reflect pricing over a longer historical period, when the tax changes were uncertain.
The Act includes other changes that may affect the value of cash or other assets on the balance sheet. Examples include changes to the treatment of net operating losses (NOLs) and deemed repatriation for overseas assets:
- NOLs deduction: among the notable changes in the Act are two changes to NOL provisions. First, NOLs arising in tax years beginning after 31 December 2017 would be carried forward indefinitely but may not be carried back. Second, the Act changes the amount of an NOL that a taxpayer may use to offset taxable income each year. The changes could affect the current value of NOLs.
- Deemed repatriation liability for overseas assets: the Act will shift the US to a territorial system, where foreign profits will be exempted from US tax. To transition to the new regime, the Act requires a deemed repatriation of existing overseas cash as well as for noncash assets. Companies will need to account for this tax liability.
The impact of the Act will vary by industry. Incorporating the changes into an analysis is more complex than solely reducing the income tax rate. Many of the changes will influence multinationals in complex ways, and certain provisions of the Act may change over time or expire altogether. Incorporating the effects of the Act into each specific valuation will require significant analysis to fully understand the impact on any given company or asset.
Changes will also affect the cost of capital, and it may be difficult to measure how the market equity risk premium (cost of equity) will change. It is likely that market participants will regard the expected profits given the new tax rates as riskier or less certain, which may increase their required rate of return, partially offsetting the gains.
Similarly, in the market approach, the observed increase in market multiples may reflect the expected changes in tax rates but also reflects companies’ strong performance and growth expectations. As always, it will be important to consider the specific facts and circumstances.