In this US electoral season the issue of corporate tax reform comes up frequently. Both parties seem to understand the competitive disadvantage in which US corporations find themselves often due to much more generous tax policies in other countries.
Where does the US stand in terms of corporate tax rates? KPMG, the large accounting firm, provides an excellent guide to Global Corporate Tax Rates . The current corporate tax rate for US domiciled companies is shown as 40% which is composed of the top federal rate of 35% plus applicable state and local authority taxes. The KPMG guide is meant as a guide but clearly the ultimate corporate tax rate faced by companies is a function of many variables including importantly the location of foreign subsidiaries.
According to the KPMG data the US ranks highest in terms of corporate tax rates among major industrialized nations. The global average in the KPMG sample is 23.6% with rates in OECD countries slightly higher at 24.8%.
In the last ten years there has been a race to the bottom in terms of corporate tax rates. Countries have been lowering their tax rates as an incentive for companies to relocate to their jurisdictions. In the KPMG sample we find seven countries with a zero corporate tax rate. Some well-known tax locales with no corporate taxes include Bahamas, Bermuda, Guernsey and the Isle of Man.
What are the investment implications of lower US corporate taxes? Lower corporate taxes would most likely make US domiciled companies more valuable as after-tax profitability would be enhanced. By how much? To address this question we resort to using a simple discounted cash flow approach.
The basic idea behind using a discounted cash flow approach relies on using estimates of future cash flows to the company and discounting those cash flows back to the present by using the weighted cost of capital.
Our analysis is based on a discounted cash flow model built for a hypothetical company where the only two parameter inputs that we vary are the applicable corporate tax rate and the level of debt financing. What do we learn from this exercise?
From a pure valuation perspective it is unambiguous that a lower corporate tax rate will result in greater gains for shareholders. Basically, the revenue foregone by tax authorities is now available to shareholders of the company.
But there is an offset in the valuation model via the discount factor of those now higher corporate cash flows. Specifically, assuming the same capital structure, the cost of capital will increase as the tax advantages of debt financing are diminished.
Say corporate taxes go from 35% to 20%. The after-tax cost of debt to the company yielding 5% goes from 3.25% to 4% (the calculation is (1-Tax rate)*Yield). The net effect of lower corporate taxes is a higher weighted cost of capital (assuming no changes to the capital structure or risk profile of the business). A higher cost of capital implies lower a lower valuation assuming unchanged cash flows to equity holders.
The offsetting impact of a higher cost of capital in discounting cash flows is under most scenarios likely to be of lesser importance to the valuation of the firm compared to the value enhancing effect of higher after tax cash flows.
Some of our conclusions:
- A lower corporate tax rate will under most scenarios result in higher firm valuations
- The effects of tax cuts are non-linear as the first few percentage points of tax cuts lead to proportionally higher rates of firm value appreciation
- Going from a 35 to a 30% tax rate results in a greater increase in firm valuation than going from a 30 to a 25% tax rate
- Firms using more debt financing will benefit from lower tax rates but less so compared to firms who do not use debt very much
- Firms with low debt to equity in their capital structures will increase the most in value
- This is due to the diminished value of the deductibility of interest expense and the increase in the weighted cost of capital
- Companies in the Health Care and Technology sectors typically rely less on debt financing and will thus benefit the most from lower corporate taxes
- Firms in industries with traditionally high levels of debt financing such as Telecom and Financials will benefit the least from a valuation perspective
- Firms with significant tax loss carry-forwards will not be as enticing to merge with as the value of their tax credits are diminished under lower corporate tax rates
- We don’t believe that foreign cash repatriation will instantaneously convince US corporations to invest more domestically
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Eric J. Weigel
Managing Partner, Global Focus Capital LLC
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