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|An Alternate Tax Bill View|
By Rich Mowrey
Takeaway: Will the prospective tax reduction impact business value directly? Or indirectly? Or not at all?
Have you turned on any of the finance and investment channels in the past few weeks? If so, you are aware that there is a lot of speculation on the impact of the proposed reduction in the corporate tax rate. The rising stock market may have a measure of this in it, but there are probably other more important factors at work. The question is: Will the reduction in the tax rate translate into higher stock prices and higher values for closely-held businesses? If so, what will the relationship be to the tax reduction? Is it a direct relationship, or an indirect relationship related to capital investment increases and/or market share growth? Or is the situation a lot more complex and much less predictable?
Business appraisers provide valuation services for privately-held businesses. Some of these valuation professionals now assert that the anticipated tax reduction will directly increases public and privately-held business value. This view in its simple form is erroneous. It is an overly naive look at what, at a minimum, is a potential complex market development. Markets are dynamic. History tells us that all players are balancing risk and reward on a continuing basis...and taking actions.
A different, dynamic view argues that there may be little long term change in value as a direct result of the tax reduction. There may well be some indirect value increase due to the stimulation of the economy, total market growth and individual company market share increases. These, however, are secondary (indirect) effects on value.
Let's step back and look at how good managements handle costs in any operating system. This approach argues for the proposed tax cuts to be treated just as any other cost. Let’s take a look at the five scenarios in the very simple business income statement provided in the chart below:
Scenario A is the status quo (before any tax change). Scenario B is the same company with only the change in tax rate and the reset tax expense reduction. What, in the base case (Comparison of B to A), you see is an increase in after tax cash flow. But, is this really what will occur. It may...but only in the very, very short term.
Looking at Scenario C and D you will see a corresponding expense reduction in the cost of raw materials (Costs of Goods Sold) that yields the same net cash flows. This raw materials cost change in Scenario C and D could initially result in the same after tax cash flow as the tax reduction in Scenario B. But if you look at the income statement shown for Scenario D, you see a much more likely free market result. Most management teams would reduce prices due to a dramatic raw material cost drop almost immediately to meet market competition. They would do this to maintain market share and to sustain the return on the market value of assets.
A change in a material cost would not have changed the operating and financial risks in the markets. Consequently, competitive forces would drive players to adjust prices corresponding to the COGS reduction to hold market share. Any company that made the decision to “put the raw material cost reduction” in their pockets (attempt to take it to the bottom line) as in Scenario C would be risking an eventual loss of revenue, given that customers could find the products at lower prices. Companies normally reduce prices after experiencing such a raw materials cost reduction…almost immediately. This step maintains the return on assets as shown and holds market share. This outcome would be due to timely competitive actions. Experience tells us it would happen!
Scenario E shows a price reduction consistent with the reduced cost of operations from a lower corporate tax rate. Consequently, it can be argued that management would act with the same insight and motivation as in Scenario D. This adjustment to the "expense reduction" due to taxes may take a part of a cycle to become evident.
Basic financial theory and valuation principles still apply. Unless the risks changed, the after tax risk adjusted rate of return on assets should not change. If a 20% return was the right rate before a major cost change within the system, it should not change. The operating adjustments will migrate toward the same after tax cash flow required before the tax reduction. Consequently, there should be no direct increase in value for a company once the operating changes settle out as a result of the tax rate reduction. There certainly could be a value increase strictly due to astute competitive actions. The company could eventually grow both revenue and absolute cash flows as a result of the market changes and management’s timely actions. Capital investments prompted by such growth expectations could also propel an improvement in the benefits of ownership. Once the markets adjust to the new tax rates, these historic business drivers will be the primary causes of any change in business value.
Two points can be made from reviewing this simple example. First, it should be clear that all “costs” in any system are inputs to the operations. Taxes seem to be different in our minds because they are an artificial expense imposed by governments. But just the same, taxes are an expense (a consumer of cash) in the operating system and impact net after tax cash flow. Taxes are an expense. Lower expenses provide the opportunity to lower prices in an effort to hold on to customers, maintain a balance in operations, and achieve an appropriate risk-adjusted return.
The required returns for any business are based on the associated risks. Individual business risks do not change relative to alternative investments. Let's ask the question: Is the business result shown in Scenario B likely to persist if competitive forces become operative? Is the return relative to alternative investments likely to be assessed differently? Probably not in the short term and certainly not in the longer term.
Second, the old axiom that: Corporations do not pay taxes, people (customers) do...is important to remember! Whether the cost reduction is for raw materials or corporate taxes competitive market participants will analyze the situation and act. Most will pass the reduced costs along to the customer in the form of a price reduction or use it to improve operations. In doing so they seek to maintain the required rate of return on investment (market value of tangible and intangible assets). The valuation principles of alternatives, substitution, and future benefits all still apply!
Finally, a review of Scenario E vs. Scenario B reveals that the projected collection of corporate taxes by the government might be less than projected in the static model. Market forces may indeed cause the future economic impact from a tax reduction to be in variance with expectations…in numerous ways! And…dare we hope…that at least part of the “cost reduction” from tax expenses might find its way directly into increased wages!
Richard Mowrey is a recognized expert with over 30 years of experience in business valuation and ownership transition. He is the #1 international best- selling author of the critically acclaimed business owners’ planning reference: When is the Right Time to Sell My Business? You can learn more about Richard’s background and services at RichMowrey.com.