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"Can’t You See This is The Land of Confusion": Uncertainty and the Tax Cuts and Jobs Act

I will admit that I hesitated before referencing a song in any way associated with Phil Collins (in this case in his Genesis persona) since I know he can be a divisive figure-but I was desperate for any kind of link for this e-mail so it will have to do.

In last month’s article, I gave you some of my initial reactions to the effects of the Tax Cuts and Jobs Act on business valuations. While it remains the case that the lower corporate tax rates for C corporations increase cash flows and therefore potentially increase values using an income method of valuation, in a couple of other situations the effect of the new law on value is not quite as clear.

The Act restricts the deduction of interest expense to the extent that it exceeds 30% of a company’s earnings. This would therefore increase the tax burden on a company with a lot of debt, offsetting some of the benefits of the lower tax rate. However, this provision does not affect companies with annual revenues of less than $25 million. So the effect of these provisions on the value of small companies and those with only moderate leverage will be negligible.

In the case of larger companies, it is often appropriate to determine a discount rate used in present value calculations that incorporates both the cost of a company’s equity and its cost of debt. The debt component has historically been calculated by multiplying the interest rate at which the company can borrow by one minus the tax rate to reflect the tax benefit of interest deductibility. With a lower tax rate, the cost of debt therefore increases causing the final discount rate to rise. All other things being equal, when the discount rate goes up, the resulting value comes down. This may mute the effect that the lower tax rate would otherwise have had through higher cash flows. Even this conclusion may be further affected by the fact that for some companies not all of the interest is deductible (see above) making the cost of debt calculation even more difficult.

And, to add to the uncertainty, Congress has provided for the sunsetting of the various the new tax provisions which makes it more difficult to project the cash flows of a company into the future.

All these changes will keep me entertained for the foreseeable future since they probably give even more reasons for two valuation experts to differ in their final conclusions of value (as if we needed any more).