Q1 2018 M&A Update: How the Tax Cuts and Jobs Act Will Impact Private Company Valuations

Business owners have been asking how the new Tax Cuts and Jobs Act (TCJA) will impact private company valuations. CPA’s, attorneys, and business valuation experts have composed analyses, and we will summarize the significant areas that impact our clients – the owners of privately held businesses.

In general, most businesses will pay less in federal income tax due to lower tax rates beginning in 2018, which translates into higher after-tax profits and after-tax cash flow. As businesses are typically valued using EBITDA, which is computed “pre-tax”, most of the valuation methods would not change. However, one valuation method, Discounted Cash Flow, would be affected.  Those businesses that are primarily valued using this method could experience an increase in value, although in most cases, not as much as one might think. In any case, we would not anticipate changes in the tax law to have a significant impact on transaction valuations.

When valuing a private business, experts must consider the economic conditions, industry trends, and regulatory environment that exist on the valuation date. In addition, the access to and cost of capital for a transaction, consisting of debt and equity weigh heavily into the equation. Currently, the market is very strong, and debt is relatively inexpensive, so that component of the equation is favorable. For the purpose of this discussion, we will limit the valuation impacts to those affecting the value of an enterprise stated on a “cash free” and “debt-free” basis.

Discounted Cash Flow (DCF) method and weighted cost of capital (WACC)

The most notable impact will pertain to the Discounted Cash Flow (DCF) method of valuation and on the computation of the weighted average cost of capital (WACC). Free cash flow for a “C” corporation specifically will increase by the reduction in the tax rate from 35% to 21% - which computes to a 40% reduction in the rate. While EBITDA is computed by adding back depreciation and taxes to net income, taxes paid must be deducted from EBITDA when forecasting free cash flow in a DCF computation. This means that with taxes reduced, future cash flows will increase. While depreciation is added back, capital expenditures are deducted from future free cash flow. However, the new tax law contains enhanced depreciation tax breaks, which will typically be used by businesses to take advantage of growth opportunities and increase future cash flow. The amount of this increase cannot be estimated in the DCF analysis.

The next variable which affects DCF valuation is the weighted cost of capital (WACC), which is impacted by both the cost of equity and the cost of debt. The after-tax cost of debt is computed by deducting the tax savings from the interest paid, so lowering the tax rate actually raises the cost of debt component of WACC. While the new law includes a limitation on the amount of interest that can be deducted for taxes, companies with less than $25million in revenue are exempt from the interest expense limitation. The pre-tax cost of debt is generally less expensive than the cost of equity, so the mix of debt to equity on future estimated cash flow will affect the DCF valuation also. While the future cash flow and the cost of debt will both increase with the new tax law, it is generally true that valuations using the DCF method should increase based upon the new tax law.

The effect on the market approach for private companies is more difficult to estimate, as this method relies on actual transaction history, and there is very little transaction history post passage in 2018. A general statement is that there should be some positive impact, as buyers are buying the future, and the tax law will lower taxes on “C” corporations, and certain types of pass-through entities.

If all else remains constant in the business, the new tax laws should have a positive impact on valuations, although the amount is difficult to determine. However, a business with demonstrated growth opportunities, a solid management team, and consistent profits will still command the most interest from acquirers, regardless of changes in tax laws. For additional information on the valuation of closely held businesses, please contact the professionals at Corporate Investment.