Just came back from the 2nd round, the questions were not too hard but somehow I didn't handle this one well.
I was ask: what happens to P/E if all of a sudden the tax rate got cut? I said it will stay the same as both P&E will increase, not sure if I answered it correctly.
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Why do you think P would increase?
Any red flags?
......
Problem I see is that equity multiples use the market value of equity. Which is different than the equity value you calculated by using enterprise value. I'm honestly not 100% sure of this, but I think there should be a difference between the two calculations for equity value.
Assuming valuation comps do not change and no crazy price reactions all else equal ... tax rate getting cut would increase earnings per share which would increase EPS. P/E multiple falls.
Yeah that's exactly what I thought. P/E = Equity Value/Net Income. Tax rates getting cut means your net income increases. Your numerator would not increase, as Equity Value should not change when taxes change. Equity Value = Common Shares Outstanding * Share Price. Neither of these are directly affected by tax rates.
I think this is a tricky question but the answer is (as it usually is, "it depends") because there are multiple effects here, or it could be that I’m over-thinking the question: 1) decrease in tax rate increases earnings so as long as price is constant P/E should fall 2) since this is a "sudden" decrease you have to assume it is not priced in, so price should change here. decrease in tax rates increases Free cash Flow which increases Enterprise Value which assuming debt stays constant increases Equity value 3) A decrease in taxes reduces the benefit of the interest tax shield so it INCREASES the weighted average cost of capital, which reduces Enterprise Value which i think should reduce Equity Value. The magnitude of this effect of this depends on the amount of debt in the capital structure. 4) It could also depend on the amount of NOL carry-forwards or deferred tax liabilities a company has as well. A decrease in tax rate I would think should hurt a company with NOL Carry-forwards (by permanently impair a DTA) and help a company with deferred tax liabilities (by permanently reducing the amount of future taxes owed) Would be very curious to hear what other people have to say.
Haha you are right, this seems like a pretty complex question: http://cba.unl.edu/research/articles/357/download.pdf
I would never have thought to go into that deep of analysis
If tax rates includes cap gains tax then P could increase as investors are more willing to take on risks.
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