Business Valuation and The New Tax Law

The Tax Cuts and Job Act signed into law by President Trump in 2017  will have both long term and short term effects on business value as the provisions in this legislation will require more complex modeling by business valuation professionals for after tax cash flows and the cost of capital calculations.

Under an income approach the value of a company is related to the ability of the entity to generate after tax earnings and cash flows. The lower tax burden in the new tax law should increase after tax cash flows. However, terminal value cash flows used in the discounted cash flow method of valuation will require additional considerations when reviewing management projections as some provisions of the law are short term and will expire. As terminal value is based on expected cash flows into perpetuity, this calculation will become more complex and subject to challenge by third parties involved in litigation related to company value.

As company cash flows are discounted by the weighted average cost of capital( WACC ) to adjust for a company’s perceived risk, the lower tax rates will increase the complexity of this calculation as both the cost of business equity and debt will be impacted .  The use of historical cost data to estimate  market risk premium will not have incorporated in this data the impact of the new tax rates. Systematic Risk( BETA)  will also be impacted when calculation the cost of capital. The capital asset pricing model of valuation will be effected by reduced tax rates and valuators will now need to consider the limitation on interest deductions in their  calculations.  As a result, careful consideration must now be given to what assumptions are made when preparing cost of equity models for use in business valuation engagements.

The provisions of this new tax law are complex and will impact business valuations and business sale terms .  Detail analysis will be required to incorporate the impact of the new legislation in valuation models.  The need to properly document assumptions will become critical when assessing the value of a company.