Stock market analysts and commentators have credited the Tax Cuts and Jobs Act with boosting market prices during late 2017 and early 2018. As we have discussed in previous articles, the tax code reform has many nuances with unique consequences for each business. We would like to isolate one significant change in the tax code and discuss its impact on business value — the Federal corporate income tax rate cut from 35% to 21%.

As detailed in a previous valuation article, three methods are commonly used to value a business. We focus here on the income approach, which reflects the fact that the value of a business is equal to the sum of its future cash flows discounted to present value. Clearly, a lower corporate income tax rate directly increases the future cash flows of a business, as shown in the example below.

Corporate Tax Rate 35% 21% % Increase
Pre-tax income $1,000,000 $1,000,000
Taxes (350,000) (210,000)
Free cash flow $650,000 $790,000 21.5%

Regardless of the amount of pre-tax income selected, the 21.5% increase to free cash flows stays constant.  As such, the Federal corporate tax rate decrease from 35% to 21% increases the free cash flows of a corporation by 21.5%, assuming all other factors are held constant.

The next step of the income approach is to discount the free cash flows to present value.  Assuming the discount rate (i.e. rate of return) an investor would accept/demand for an investment in the business remains the same, the 21.5% increase in cash flows results in a 21.5% increase in company value.  Accordingly, we conclude that, all other things being equal, the decline in the corporate tax rate from 35% to 21% increases value by 21.5%.

Though this article focuses on the direct impact on value of the corporate tax rate change in isolation, it should be noted that the decline in the rate could have indirect impacts on value, as well.  For example, after-tax borrowing costs will increase as a result of the federal tax rate decline, which may impact the weighted average cost of all capital, which in turn impacts a company’s value.  In addition, other provisions of the new tax law may also impact value.  For example, the more favorable depreciation rules associated with the new law could lower the effective tax rate of a company, resulting in increased cash flows, and thus increased value.  In general, and all other factors being equal, we believe that the value of most companies will increase as a result of the new tax law, but just how much is a function of several (perhaps many) factors, several of which are difficult to evaluate.

For more information or questions about business valuation, please contact David Angelucci at 859.425.7695 or dangelucci@deandorton.com or Shelby Clements at 502.566.1052 or sclements@deandorton.com.

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