Hi all,

I have some questions on an undying topic that's continuously discussed on the street: how tax rate affects EV valuation of companies. Some people argue it's positively correlated to EV while others argue it's the opposite.

Based on my experience/observation, I think it's positively correlated especially when using unlevered DCF and simple EV formula. In the former case, increase in tax rate decreases WACC (EV goes up). And also in the latter case, cash and cash equivs go up as tax rate goes down (EV goes down).

I heard some people saying it depends on valuation methodologies, so I wanted to hear your opinions. Has anyone observed clear relationship b/w tax rate and EV using multiple, comps, or previous transactions? What are your thoughts in general? Thanks for your insight in advance.

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Positive correlation, as in the higher the taxes the higher your EV? Probably the stupidest thing I ever heard.

Your tax rate technically would not impact any market approach at the EV level - all metrics are pre-tax.

And in a DCF, a tax rate has a much more material impact on cash-flows than it does on the discount rate...

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MS to above, I've heard stupider things. That said - based on quick math - tax rate would be positively correlated with value only in companies with over ~85% debt capitalization. This obviously isn't applicable to most firms, so in most circumstances, tax rate and EV and going to be negatively correlated.

Hey Timmy you've got the point that I missed. Most of the firms I looked at had very high debt cap ~70% and above. Can you elaborate more on your quick math. I am interested to see how to quantify this relationship. Thanks for the comment

Just ran a DCF with basic numbers and sensitized tax rate and % debt. I doubt you will be able to quantify the relationship to a point where it is a quick heuristic, there are just too many factors at play

Indeed I also don't think I can quantify the relationship like IR vs. Bond price, but I think I am gonna try making something like rule of thumb with a lot of samples. Thanks for the insight

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Keep in mind when you run your DCF, you should be looking at the target capital structure, not the current capital structure. I have no idea what academics would say the optimal % of debt is in the capital structure and it'll obviously depend on the type of companies you're looking at, but >70% just intuitively feels high to be the 'target'.

Agree that 70% does feel intuitively high but given that he's seen a couple of those, perhaps its an industry-wide thing? I'm assuming the high debt would mean an asset heavy industry? Kind of curious what industry you're working on, if you don't mind, could you share?

Don't mean to steer this the wrong way though!

Thanks for asking, I can see where this can be a potential pothole.

I guess in summary this would be it: negative correlation between tax rate and enterprise value up to a debt capitalisation of 70-85%, after which correlation could be positive.

Reason: Tax rates tend to impact your cash flow significantly, so much so that the fall in discount rate would be unable to bring up the overall enterprise value of the target.

PE interview question: EV increase with tax increase? (Originally Posted: 02/27/2016)

This is a question I got in a PE interview to answer later and would like to check if my answer is correct. Thanks for your help:

The question:
We are valuing a firm with perpetuity approach: EV = FCFF/WACC. If tax increases by 1%, which firm benefit from it and see an increase in Enterprise value?

My answer: EV decreases in most cases when tax increases, but if a firm is financed 100% debt and 0% equity the value stays the same with 1% increase in tax rate. The case in which EV would increase with 1% increase in tax rate is if equity value of the firm was negative and debt was more than 100% of the EV.

What do you think is the correct way to answer this question?

Thank you.

I'd assume this has something to do with after-tax cost of debt. Probably need to assume this isn't 100% equity financed.

Tax rate increases -> lower after tax cost of debt -> decrease in waac -> increase in EV

If Taxable Income > 0,
then Tax Expense increases,
therefore cash flow decreases,
therefore EV decreases...

If Taxable Income WACC. WACC = Unlevered IRR = required unlevered rate of return. All else equal, this most likely would not change with a change in prevailing tax rates. The WACC metrics that people commonly quote are based on a public company methodology which in theory gives you the implicit unlevered rate of return the public market is requiring at a point in time. Your required rate of return as an investor may be, and often is, different. Hence you wouldn't always buy at the public market price.

Therefore in your example, where you are valuing a company (as opposed to calculating implied public market WACC), FCF changes but WACC doesn't.

(oversimplification but not grossly inaccurate...)

Coast:
people don't understand WACC. WACC = Unlevered IRR = required unlevered rate of return. All else equal, this most likely would not change with a change in prevailing tax rates. The WACC metrics that people commonly quote are based on a public company methodology which in theory gives you the implicit unlevered rate of return the public market is requiring at a point in time. Your required rate of return as an investor may be, and often is, different. Hence you wouldn't always buy at the public market price.

Therefore in your example, where you are valuing a company (as opposed to calculating implied public market WACC), FCF changes but WACC doesn't.

I am not sure I agreewith this part. There is no such thing in practice as "required unlevered rate of return". Because "unlevered" investors don't exist. In simple terms, there are investors in equity or in debt, there are no investors that invest in public companies on an unlevered basis (because unlevered FCFF is theoretical), and each of them will have certain required rate of return for themselves and this required rate of return won't depend on the company's tax rate. So if the bank wants to make 5% IRR on a senior loan, it will price loan accordingly irrespective of whether the borrower has 20% corporate tax rate, 21% tax rate or 40% tax rate.

Coming back to this example, if the company sees its tax rate increase, it will see after-tax debt funding becoming cheaper (because, as I said above, pre-tax debt funding won't change) hence WACC, implicit or explicit, will decrease.

So with increase in tax rate, unless there are NOLs, both numerator and denominator will decrease. But it is likely that numerator decreases more hence EV overall decreases, so I agree with your ultimate conclusion, but not with WACC logic...

It will stay the same:

EBIAT/NOPAT FCFF – numerator

Ke (%e) + Kd (%d)(1-T) WACC - demoninator

Both have "T" taxes in them so a 1% increase/decrease in both the numerator and denominator would keep the overall value (EV) the same from before the tax change

My hunch here is they're looking for a solidly explained "maybe". Consider a 1% tax increase.

In the case that the firm is generating operating losses, you have the WACC decreasing and tax shields becoming more valuable, so you're unambiguously up.

In all other cases (mixed losses/gains or all gains), you have two dynamics:
--the positive FCFFs will be diminished due to the tax increase by 0.01 * EBIT.
---WACC will be decreased by Kd * D/V * 0.01

Obviously the relative differences are impossible to know without knowing (a) prior FCFF values, (b) prior WACC, (c) Kd, and (d) D/V. As long as you point out these levers, the interviewer should be satisfied. If any more experienced monkeys want to correct flaws in my reasoning, I'd be happy to hear.

I would break it down into EV = value of equity + value of debt. Thus, EV = FCFE / (ke - g) + value of debt. Cost of equity (ke) and growth (g) are not affected by tax rates, so the moving pieces are FCFE and value of debt.

With higher tax rates, your FCFE decreases due to the additional tax on the income, leading to a lower value of equity. Value of debt is higher due to higher tax shields. So EV could go either way, and firms that benefit more from tax shields than their additional taxes will see an increase in EV.

Seriously? Having a higher tax rate should almost never increase your EV. Why? Because the government will not give you cash if you persistently operate at a loss for tax purposes. Accordingly, a higher tax rate inevitably means higher cash outflows, capiche? Sure, you can boost your debt tax shield for WACC purposes, but at very thin capitalizations you are just implicitly building NOLs. In some limited circumstances, maybe a higher tax rate helps you if some serious structuring is taking place, but it generally seems pretty unlikely.

Interview question - EV with different tax rates (Originally Posted: 06/16/2017)

Wouldn't EV be higher for the country with the higher tax rate?
EV= Market cap + debt - cash; ignoring preferred shares/ min. interest
The company that has a higher tax rate would have less cash on hand, therefore EV would be higher in this scenario.

This is my guess: tax rate impacts the WACC calculation. Higher tax rate --> Lower after-tax cost of debt --> Lower discount rate --> Higher PV of free cash flows and therefore a higher EV. Same effect on the terminal value - smaller difference between the discount rat and growth rate, therefore higher terminal value.

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