January 2018 By Mark Gehrig, Managing Director Whoever thought that the House and Senate bills representing the Tax Cuts and Jobs Act (TCJA) would ever be reconciled and become law, or at the very least, would be signed into law before the end of calendar year 2017? Seemingly, the stock market placed a high probability on that event. That bet, placed by the market on a more business-favorable tax law change, is believed by many (but not all) to have been a significant contributor to the 20%-30% run-up in the stock market witnessed since November 2016. One notable disbeliever, Warren Buffet, is quoted to have said in early January 2018 that the magnitude of the tax cut is not reflected in the stock market yet. More about that later. In the weeks and months before the signing of the TCJA on December 22, 2017 and since, there has been no shortage of articles and webinars summarizing all or portions of the new tax law. Those summaries, and their authors, are varied; law firms, accounting firms, trade associations, investment bankers, etc. Because Chartwell is neither a tax advisory nor accounting advisory firm, we will leave the detailed explanation of the provisions of the TCJA to those folks that specialize in such matters. Like many, however, Chartwell is a stakeholder in the tax law changes for several reasons, not the least of which results from our role as a provider of financial advisory, corporate finance, and business valuation services. Chartwell provides business valuation services for many reasons: ESOP, fairness opinion, financial reporting, gift and estate, restructuring, corporate planning, and equity compensation, to name a few. No matter the purpose of the business valuation project, in seemingly 99 out of 100 instances – after-tax cash flow is a key data point. A change in the tax law is big news to anyone practicing, or affected by, business valuation. This article will concern itself narrowly with our belief of how the TCJA, and its effect on certain key inputs into the business valuation process, could affect the output of many business valuation projects. Taxes affect individuals, corporations, and the hybridized category of pass through entities (PTE). This article is concerned solely with certain high visibility tax law changes affecting taxable C corporations. A discussion of PTE specific tax law changes will be reserved for a future installment of Insight. Clearly, the headline provision of the TCJA is the reduction in corporate income tax rates from 35% to 21%. Were this the only tax law change to have been made, the result would be an increase in corporate after-tax cash flow and, in turn, an increase in the value of many businesses (all else held constant). In addition to lower corporate tax rates, corporate cash flow benefits will also result from the TCJA’s provision allowing for 100% immediate expensing, either as first year/bonus depreciation or §179 expensing, of qualified new and used property (with certain limitations). This change will accelerate tax deductions (although with a smaller benefit because of the tax rate reduction), and will increase cash flow and resulting value. Importantly, however, this change will be phased out during the 2023-2027 period. Offsetting factors are represented by a variety of reductions in tax credits and deductions. A notable example is the limitation on the amount of interest expense that will be allowed as tax deductible (30% of adjusted taxable income, equal to EBITDA in 2017-2021 and EBIT thereafter) for companies with average gross receipts of more than $25 million. While this change may have a secondary effect in a low interest rate environment, such a change is important to any acquisition valuation analysis. Further, net operating losses (NOLs) will be able to be carried forward indefinitely; however, only 80% of taxable income in future years may be reduced by the NOL. NOL usage carry back has been eliminated. Not to be ignored is the increasing effect on the discount rate that lower corporate tax rates will have on the after-tax cost of debt embedded in the weighted average cost of capital (WACC). The WACC is the discount rate employed when estimating enterprise value. There is an inverse relationship between discount rate and value. Companies that have had high effective tax rates, are capital intensive, and have restrained their use of financing will likely enjoy the greatest cash flow pickup from the foregoing corporate provisions of the TCJA. A simple example illustrating the estimated difference in combined federal and state corporate tax rates that might be used in a discounted cash flow analysis is presented below: Viewed in isolation, the increase in an after-tax dollar resulting from the foregoing change in combined federal and state corporate tax rates is approximately 21.5%. As a further example, utilizing the revised tax rate, capital recovery rule changes, and interest expense deduction limitations (but leaving all else constant) results in an indicated equity value change of approximately 19.1% under the TCJA when compared to the prior tax law. The foregoing example is admittedly simplistic and is presented as an illustration of the computational results of a single scenario. Prior to the tax law changes brought about by the TCJA, the most recent major shift occurred in the mid-1980s. It has been a long time coming, but it has arrived. However, it is reported by some that there will be tweaks to the new law as its ramifications are better understood. As such, the TCJA may be a bit of a work in progress and while certain changes cannot be predicted at this time, other provisions are known to be temporary and may have a shelf life under current law of ten years or less. Further, if an after-tax cash flow forecast based on the newly minted law is believed to introduce additional forecast risk meriting an additional risk premium in the discount rate (let’s say 200 basis points), a noticeably muted equity value uptick may be the result as indicated in the following table: Additionally, it should be noted that from an international perspective changes in the corporate tax law to a more territorial system (taxes companies only on U.S. earnings; foreign earnings are excluded from the tax base and repatriated cash would be untaxed) are designed to incentivize the on-shoring of overseas profits. Theoretically, there will be no incentive for corporations to headquarter (and allocate income) off-shore because U.S. corporate rates will be competitive. The increase in corporate profits in addition to the deemed repatriation of profits could create additional capacity for investments, including acquisitions. The M&A market is currently characterized by an abundance of capital, a dearth of quality targets, and relatively high valuations. While increased cash flow to corporations can be used for other purposes, such as deleveraging and share buyback, such conditions could foretell continued rich valuation multiples in the near term. It should be noted that during 2017, business appraisers that utilized market and income approaches may have experienced a slight mismatch between the key inputs reflected in the guideline public company/M&A appraisal methodologies and the discounted cash flow methodology. While it is believed by many that the potential for tax reform has been, to an unknown extent, imputed by the market in its valuations, business appraisers using a discounted cash flow model will typically reflect the tax regime in place as of the date of valuation. Part of the beauty and the struggle with using multiple appraisal approaches and methodologies is that, at certain times more than others, each methodology may reflect a unique investor perspective. Reconciliation (of appraisal methodologies) is the by-product. Going forward, however, the unifying effect in key appraisal methodology inputs (e.g., the tax rate) caused by the Oval Office signing the TCJA on December 22, 2017 will hopefully bring the various appraisal approaches and methodologies back into closer harmony (to the extent that is ever possible). Broadly, the tax law change is intended to prove the theories of trickle down/supply side economics and further invigorate the U.S. economy. Yet another reason to look forward to the new year.