How Tax Law Changes Could Impact the Value of Your A/E Firm

Like it or not, with an incoming Trump administration, and Republican control of the House and Senate, we’re likely to see some significant changes in the Federal tax code in 2017. In addition to cutting and simplifying the personal income tax brackets, the incoming administration has signaled that it will propose a dramatic reduction of the Federal income tax on corporations from 35% to 15%. It has also suggested that the same cut will apply to pass-through corporate entities, such as S-corporations, LLCs and partnerships.

So what will this mean for the typical A/E firm? Notwithstanding other changes that might eliminate or limit various deductions, such cuts will mean significant cash savings for companies and their owners. It would also mean a substantial increase in company stock values.

Let’s take the example of a company generating $30 million in net service revenue and $5 million in taxable income. Under the current corporate income tax environment, such a company might be paying as much as 35% in federal income taxes, perhaps as much as 40% in combined federal and state taxes, which would equate to $2 million annually. Under the proposed corporate income tax cut, the same company would have a blended federal and state rate of 21.5%, or $1,075,000 annually (assuming state taxes are deductible).

Assuming this company’s stock is valued at 5x earnings (on a non-marketable, minority interest basis), its total equity value would increase from $15,000,000 to 19,625,000, an instant jump of $4,625,000 (5x the annual tax savings of $925,000), or a whopping 31%. I personally suspect this sort of calculus was at least part of the reason for the post-election rally in U.S. stock markets.

But before you get too excited (or concerned), keep in mind that the proposed tax cuts are just that… proposed. Concern over the impact of such cuts on the budget deficit and national debt may result in these ambitious proposals being scaled back. Furthermore, other forces may have a downward impact on values. The Federal Reserve is expected to hike interest rates in 2017, and part of the proposed tax overhaul includes the elimination or limitation of the interest expense deduction for businesses. These changes would have the combined effect of increasing a company’s cost of capital, thereby reducing its value.

Using our prior example of a firm generating $5 million in earnings with an equity value of $15 million, and assuming the company has $2 million in debt bearing interest at a rate of 4.5%, and an estimated cost of equity of 18%, its weighted average cost of capital would be calculated as follows:

Original Cost of Capital Interest Rate Weighting Weighted Rate
Pre-tax cost of debt 4.5%
After-tax cost of debt 2.7% 11.8% 0.3%
Cost of equity 18.0% 88.2% 15.9%
Weighted Average Cost of Capital 16.2%

Assuming a 50 basis point interest rate hike over the course of 2017, and the elimination of the deductibility of interest expense, the company’s cost of capital would increase by 0.6 percentage points, as illustrated below.

Adjusted Cost of Capital Interest Rate Weighting Weighted Rate
Pre-tax cost of debt 5.0%
After-tax cost of debt (no deduction) 5.0% 12.3% 0.6%
Cost of equity 18.5% 87.7% 16.2%
Weighted Average Cost of Capital 16.8%

All other things being equal, this increase in the company’s cost of capital would result in a $700,000 decrease in value as illustrated in the application of the capitalization of cash flow valuation methods below.

Of course nobody knows for certain what sort of changes will actually be made to the tax code, monetary policy and other external factors that might impact companies in the A/E industry. Only time will tell. But it’s important to understand the potentially significant impact these proposed changes could have on companies’ stock valuations.