The Tax Cuts and Jobs Act (Tax Act) became law in December 2017, and now private companies and their investors must consider how the changes in tax law impact business valuations. Specifically, stakeholders should consider how the Tax Act impacts their projected cash flows and the inputs and assumptions that drive the estimation of enterprise value (EV).
Key changes that may impact company valuations include the following:
- A corporate tax rate of 21 percent vs. 35 percent
- Limitations on interest deductibility
- Net operating loss limitations
Corporate Tax Rate
The reduction in the maximum corporate tax rate from 35 percent to 21 percent is driving significant changes to business valuations. Incremental free cash flows from a lower tax rate can impact operational and investment decisions. It can affect capital allocation and investment decisions to drive top-line growth. We will explore this when we discuss the income-approach valuation methodology.
The decrease in the corporate tax rate will likely affect the value of companies’ deferred tax assets (DTA) and deferred tax liabilities (DTL). A DTA is a future asset, and if it will be used in a lower-rate environment the asset is worth less. A DTL is a future tax liability, and if the tax owed is lower due to the rate in effect, then the savings has a positive impact.
Limitations on Interest Deductibility
Companies that historically have employed a highly leveraged capital structure may see the most significant impact from the limitations on interest deductibility. The Joint Committee on Taxation estimates that this will increase revenue by more than $253 billion over the next 10 years, which makes it the highest estimated revenue raiser among the domestic business tax reform provisions.1
Beginning Jan. 1, 2018, corporate interest expense is generally deductible up to 30 percent of a company’s adjusted taxable income (ATI) plus business interest income. The Tax Act defines ATI similar to earnings before interest, taxes, depreciation, and amortization (EBITDA) for tax years 2018 to 2021.
In 2022 and going forward, ATI will be similar to earnings before interest and taxes (EBIT). Consequently, the limitation becomes more restrictive. This is consistent with the provision’s intent to incentivize near-term capital investments.
This provision may affect decisions on the optimal future capital structure for private companies in both the short term and long term. The interest expense limited by this provision is generally allowed to be carried forward indefinitely.
The Tax Act permits immediate 100 percent expensing of capital expenditures, with certain exceptions.2
For property placed in service after Sept. 27, 2017, and before Jan. 1, 2023, the allowable investment generally can be expensed immediately as opposed to being depreciated over time. There is a five-year phasedown of full expensing beginning in 2023. (There is an additional year for certain qualified property with longer production periods, such as certain aircraft.)
The provision for a 100 percent deduction generally applies to new and used qualified property. The objective of this provision is to induce investment that will benefit growth and expansion strategies.
Companies that need to purchase depreciable assets in the near future may become more attractive for private equity investors. This is because accelerated deductions on investment property could result in an increase in after-tax cash flows in the year of investment.
There is a potential for considerable interplay between the new immediate expensing and new interest limitation provisions. The deductions for capital expenditures are added back into interest limitation calculations until the end of 2021. This may provide a near-term ability to maximize the deductibility of business interest expense while still using the allowance for immediate expensing. From a liquidity perspective, companies should assess their funds to properly understand their capacity for immediate capital expenditures.
Net Operating Loss Limitations
A component of EV is the present value of the net operating loss (NOL) tax benefit. The Tax Act changed the rules for NOLs in several ways:
- NOL carryback deductions are disallowed
- NOL carryforwards are carried forward indefinitely (compared with the previous limitation of 20 years)
- Any annual NOL benefit is capped at 80 percent of taxable income
The new limitations and the indefinite carryforward generally apply to NOLs arising after 2017.
Companies that have generated or acquired NOLs should consider how NOLs will be used and the impact on the present value of this benefit. The NOL benefits will be less valuable than previously due to lower tax rates.
Valuation Methodology Considerations
The two primary methods used to value private companies are the market and income approaches. Both methods, associated processes, and models need to consider the impact of the Tax Act.
– The market approach uses data from guideline public comparable companies (GPC) and guideline transactions (GT) as the basis of comparison to a company’s performance and valuation. It uses market-based multiples of relevant financial metrics from comparable company and transaction market data.
The process of selecting a range of reasonable GPC or GT multiples under the new Tax Act may result in a change in the multiples when assessing comparability of historical multiples in relation to companies’ revenue and EBITDA growth, working capital needs, and leverage models, for example. Transactions priced prior to passage of the Tax Act may not have priced in the consideration for the new law, while public company multiples are constantly changing based on fluctuations in the public markets.
Differences in the underlying leverage ratio versus the comparable data set may require an adjustment to the data to estimate EV. Investors in companies within capital-intensive industries should consider the benefits from investments needed to drive strategy and value.
Income approach (the discounted cash flow method)
– The use of a discounted cash flow method requires consideration of future cash flows, terminal value at the end of the projection period, and an appropriate market-based discount rate.
The Tax Act may impact each of these components and associated models.
The projected cash flows to the company may be affected in the following ways:
- The lower tax rate of 21 percent should lead to higher free cash flows to the company.
- The immediate expensing of capital expenditures will impact the computed EBIT and total free cash flow projections because less cash will be spent on tax up front. The impact will likely be most significant through 2023, which is the prescribed sunset year for the immediate expensing provision.
- The impact on depreciation and capital expenditure projections will likely affect allocation of working capital and ultimately the free cash flows a company can generate.
Terminal period assumptions need to be considered. Target exit multiples should be aligned with the expectation of the company’s value in future years, which may be different from the prior year due to changes in business priorities resulting from the Tax Act. Any impact on trading multiples may affect the long-term growth model, often referred to as the Gordon Growth Model.
The discount rate, commonly referred to as the weighted-average cost of capital (WACC), will need to be reassessed in valuation models. The act may change the inputs to the WACC buildup in a few key ways.
WACC is a weighted-average between the cost of debt and cost of equity. Accordingly, a change in the target capital structure can have a significant impact on the WACC. The target capital structure used in the WACC may be based on the market or the company’s own capital structure.
Private and public companies with a high-leverage model may need to consider that some of the benefits of this model before the Tax Act may have changed after it went into effect. A market shift to a higher weighting to equity capitalization should be considered.
A component of the process to estimate the cost of equity in the WACC is the need to take public market betas, unlever the cost of capital, and relever the betas to align with the target tax-affected capital structure for the company. Changes to the tax rate and to companies’ capital structures as a result of the Tax Act will likely impact the unlevering and relevering of this input.
The cost of debt may also change for companies based on the following factors:
- The pretax cost of debt may be affected based on a company’s change in interest coverage and leverage ratios.
- The change in capital structure may affect a company’s public or implied credit rating.
- The cost of debt may be affected by the reduction in the corporate tax rate from 35 percent to 21 percent.
Impact on Valuation Models
The changes in corporate tax law have the potential to significantly impact established valuation models as a result of changes in business growth opportunities and companies’ operational and financing strategies. Accordingly, these changes may affect the views of venture capital and private equity investors.
A focus on methodology, process, and models can help companies and investors bring their valuations up to date and build confidence that the inputs and assumptions driving conclusions of fair value reflect a market participant’s perspective on current market valuations.
1 See “Estimated Budget Effects of the Conference Agreement for H.R. 1” by the Joint Committee on Taxation, Dec. 18, 2017.
2 The provision includes exceptions for real estate businesses, farming businesses, and floor plan financing to acquire specified motor vehicles for inventory.
Michael A. Zaydon, CPA, is a senior associate in the financial markets practice at PwC in New York. He is a member of the
Pennsylvania CPA Journal Editorial Board. He can be reached at firstname.lastname@example.org.
Tony Diab is a manager in the financial markets practice at PwC. He can be reached at email@example.com.
Jeffrey M. Dahlgren is an associate in the financial markets practice at PwC. He can be reached at firstname.lastname@example.org.