Changes to Tax Rates Means More Work for Business Valuators

U.S. businesses may see several tax policy changes in the coming four years with a new president taking office. Proposals discussed during the election included extending the expiring 2017 Tax Cuts and Jobs Act (“TCJA”), restoring the deduction for state and local taxes, reducing the corporate tax rate for domestic production, exempting various types of income from the income tax, repealing clean energy tax credits, and imposing new tariffs. While the impact of these proposals will vary based on the exact combination of policies implemented, a lower corporate tax rate typically means higher values for tax-affected companies in discounted cash flow and other income approach models.

It is helpful to revisit some business valuation basics to understand why lower tax rates can increase business valuations. First, a general way to consider the value of any business is as a function of its profitability, i.e., the cash flow it generates for its investors. Taxes are a cost that tax-affected businesses must bear, so tax rates understandably play a role in business profitability. Reducing tax rates has the same economic effect as increasing operating margins. All else being equal, a reduction in federal corporate tax rates results in higher after-tax cash flow for the business's investors.

Second, many investors believe that reducing taxes will increase company growth opportunities.  A reduction in the corporate tax rate could generate additional cash flow that would be available to businesses to pursue other value-creating strategies. Value-creating strategies may include increased productivity, added capacity, or new product development, which can all increase business value.

It is also important to mention that lower corporate tax rates may increase the weighted average cost of capital (“WACC”), or the rate of return investors require for an investment. The lower tax rate increases the after-tax cost of debt because of reduced interest expense deductibility. The WACC is also the rate used to present the value of the company’s earnings. The WACC has an inverse relationship with business value. Therefore, as a business’s WACC increases due to lower tax rates, the business’s value decreases.  Conversely, a reduction in the WACC will typically increase business value.

Overall, significantly lower corporate tax rates will impact business valuations, with all else held constant, valuations being higher for most tax-affected companies. As business valuators in the first year of a new administration, it will be important to think about tax rates during our engagements, including the likelihood of proposed tax changes taking effect, the impact of selecting one valuation date versus another, and other impacts that tax changes may have on business values beyond just formulaically higher taxes.