Middle-market companies are concerned about how the new tax reform legislation may affect valuations. Here is a summary of the changes that will have the biggest impact.
In December 2017, Congress passed the Tax Cuts and Jobs Act, the most significant tax reform legislation in several decades. The legislation reduces the taxes on most businesses, regardless of how they’re taxed. It also modifies certain business deductions: Some, such as depreciation, will be significantly enhanced, while others, like interest expense, will be subject to new limitations. There are other myriad provisions that corporate tax departments are still working their way through. But the question on the minds of many of our clients — especially those considering future merger and acquisition (M&A) deals — is how all these changes will affect the value of their business or one they’re seeking to buy.
While many look to earnings before interest, taxes, depreciation and amortization (EBITDA) multiples as a shortcut, fundamentally, the value of a business is directly related to the cash flows it’s expected to generate and the required return on those cash flows. Therefore, for middle-market firms, probably the best indication of business value is derived from a discounted cash flow analysis. The two key elements of this type of analysis are the projected cash flows of the business and the required return on those cash flows (referred to as a discount rate). The changes brought about by tax reform affect both of these key elements.
We believe six changes, in particular, will have the biggest impact.
Lower federal tax rate
The change garnering the biggest headlines, of course, is the decline in corporate tax rates. The C corporation statutory tax rate has been reduced from a high of 35 percent to a flat rate of 21 percent, and the corporate alternative minimum tax has been repealed. Both of these are permanent changes to the tax code. All else being equal, the drop in the corporate tax rate will generate a 14 percent increase in cash flow for every dollar of pretax earnings, which will, in turn, increase the value of the business. So far, relatively straightforward.
Bonus depreciation of capital expenditures
Significant changes were made to depreciation rules, including an increase in bonus depreciation of capital expenditures and the expansion of the types of assets eligible for the new rules. The 100 percent bonus depreciation rules will apply to both new and used assets that were acquired and placed in service after Sept. 27, 2017, but only if a binding written contract was not in place to acquire the property before Sept. 27, 2017.
Businesses can now deduct 100 percent of expenditures on qualified property, plant, and equipment made between Sept. 28, 2017, and Dec. 31, 2022. Beginning in 2023, there will be a gradual phase-out of the deductibility rule through the end of 2026. This change will allow businesses to use depreciation tax benefits sooner than under the old tax law, increasing their upfront cash flow. Given that a dollar today is worth more than a dollar tomorrow, being able to accelerate these tax benefits will give business value a boost.
Discount rate and cost of capital
So far, we’ve touched on how the changes to tax reform have affected a company’s cash flows, but the required returns for a company will also be impacted. The weighted average cost of capital (WACC) is a commonly used metric to determine those required returns. It’s made up of two components: the cost of equity and the cost of debt. It’s not yet clear whether tax reform changes will directly impact the cost of equity. However, there will be an increase in the after-tax cost of debt, due to the reduction in the deductibility of interest expense resulting from a lower corporate tax rate. All else held equal, this increase in a company’s required return would negatively impact value. This negative impact would be even greater for highly leveraged entities that are subject to the new interest expense deduction limitation, as discussed below.
Beginning in 2018, the deduction for business interest expense will be limited to the sum of business interest income plus 30 percent of the adjusted taxable income. Adjusted taxable income is defined as tax-basis earnings before interest, depreciation and amortization (EBIDA) for the 2018 through 2021 tax years. There's a cliff beginning in 2022 when adjusted taxable income is redefined as tax-basis earnings before interest (EBI), where depreciation and amortization will no longer be included in the add-back to taxable income when computing the limitation. The limitation will apply to both C corporations and pass-through entities, but small businesses with less than $25 million in average annual gross receipts for the prior three years are exempt from the limitation. Therefore, companies that cannot take full advantage of interest deductibility would be negatively impacted by this change.
Certain companies negatively affected
Generally, the impact of the changes in a company’s cost of capital and the interest deductibility will have a negative impact on business value. Companies that would be most likely experience a negative impact on value would be those that had historically experienced low effective tax rates or those that have been operating at a loss for tax purposes. Companies that are highly leveraged such that interest expense is greater than 30 percent EBITDA would also likely see a negative impact on value. While the EBITDA of a company fitting the above profile wouldn’t be affected, its cash flows would be less because it would now have to pay more in taxes, resulting in a lower value.
Positive impact on valuations but caution advised
For the most part, tax reform will likely raise business valuations. In fact, we’ve already seen some positive impact in the equity markets (as measured by the S&P 500). The higher than average returns — up 23.6 percent between the 2016 election and the end of December 2017 — could in part be attributed to anticipated reforms.
For the most part, tax reform will likely raise business valuations.
However, the full impact will only be known once companies and the capital markets better understand the details of all of the changes in the act. The legislation was enacted quickly, and a substantial amount of guidance will be necessary to interpret many of its provisions. Furthermore, some portions of the legislation may be subject to interpretation or clarification, given how Congress appears to have intended the law to operate, making it certain that we can expect some operational changes to the act going forward.
Finally, many of the act’s provisions will affect companies differently, even if they’re operating in the same industry. This means analyzing market multiples from M&A transactions will require ongoing analysis and a revisiting of the legislation as it continues to evolve.