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How Will Tax Reform Impact Business Valuations?

By: David Goldner

Thanks to the Tax Cuts and Jobs Act, signed into law at the end of 2017, businesses will experience dramatic tax cuts. Those tax cuts will not only have a positive impact on a company’s bottom line, but will significantly affect the company’s value.

If you’re an attorney and have a matter where a business valuation comes into play, or a business owner who is thinking of selling, it’s essential that you know how business values could change as a result of the new tax law.

First, let’s step back and review some of the key tax cuts and their impact on businesses.

1. Reduce Corporate Tax Rate From 35% of 21%

2. Limits on Deduction of Net Operating Losses (NOL)

In addition to the reduced value of NOLs because of tax rate decreases, NOLs may no longer be carried back and can only be used to offset 80% of a company’s income, resulting in a lower current tax benefit.

3. Faster and More Liberal Rules On Depreciation of Capital Equipment

This allows for an immediate deduction for property placed in service, resulting in a reduced current income tax liability.

4. Net Interest Expense Deduction Is Limited to 30% of EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization)

  • This limitation of deductibility will increase current income tax liability

  • The limitation may cause a consideration of adjusting the capital structure ratio between debt and equity

5. Repeal of the Corporate Alternative Minimum Tax (AMT)

While this would generally decrease current taxes, based on our experience, most private companies do not end up subject to the AMT.

When Will the Tax Cuts Start to Impact Business Valuations?

The impact on value implied by these changes should, in theory, be recognized immediately in business valuations. However, it might take the public market some time to digest the impact of tax reform as the many benefits and potential costs under the new tax law will be played out in quarterly earnings reports. For private company valuations, the impact should be seen immediately, at least in valuation calculations.

Impact of Tax Reform On Business Valuation Reports

The two traditional methods of valuing a privately-held business are the income method and market value methods.

Under the income method, either historic results are normalized to determine a normalized income amount to capitalize, or a projection of future operations and cash flows is made and a discounted cash flow calculation is made.

Historically, our firm has used about a 40% tax rate (federal and state) to determine after-tax cash flow. Under the new law, that rate is now about 28%.

The following table shows the new tax law’s impact on value:

new tax law impact on business value

In this simplistic example, you end up with a $600,000, or 20%, increase in the company’s value due solely to the decreased tax rate. Using higher or lower capitalization rates would not change the fact that the tax impact is a 20% increase in value for an entity.

Some of the most active market participants are private equity funds. These funds have historically used the greatest amount of debt possible to leverage equity returns when purchasing a company. The impact of different debt equity structures when evaluating a company and returns on equity can be illustrated as follows:

new tax law impact return on equity

The implication of this analysis when the interest is fully deductible is similar to the impact seen in capitalizing cash flow with reduced income tax rates. The return on equity is increased by 20% (8.06% divided by 6.72%) due to the simple reduction in income taxes. However, where interest becomes not deductible, the return on equity may be reduced due to mix of benefiting from reduced tax rates being offset by the non-deductibility of the interest expense. The capital structure of the company should get significant scrutiny from investors to maximize returns on equity.

The market approach to value uses guidelines based on public company and transaction data to determine the value that market participants pay for similar companies.

Company value is often determined using a multiple of EBITDA. Although one might initially think there is no impact since EBITDA is a pre-tax measure, that line of thought is overly simplistic.

As a result of tax reform, some of the potential impacts on market multiple valuations might be: 

  1. For industries that operate with significant debt to equity levels, such as financial services, oil and gas, or telecommunications, the valuation multiples in their historic deals would not reflect the multiples of the market today, reflecting the impact of lower tax rates and lost interest expense deduction

  2. Companies with high leverage will have to be evaluated differently in light of limits on deductibility of interest

  3. Acquisitions in industries that are capital intensive may need to consider a different capital structure after determining the impact of lost interest expense deductions

It’s important to remember that the market fluctuates dramatically over time based on its perception of the direction of the economy. One key factor in business valuations is the expected level of growth. Although these are company-specific in many cases, over time, the direction of the economy will move valuations. A company’s value in a strong economy will change significantly if we are heading toward a recession.

For now, the impact of tax reform appears to be pushing the economy forward toward a positive growth outlook for businesses.

Need Help With a Business Valuation?

The impact of tax reform on a company’s value and return on equity can be substantial. As a result, financial strategies for your clients might need to change. Contact us online or call 800.899.4623 to review how tax reform may impact your client's cash flow, earnings and business value.

Published June 26, 2018

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