The impact of the 2017 Tax Cuts and Jobs Act is really a story of two powerful competing forces: the increase in value that is brought about by the expectation of increased net cash flows, and the decrease in value that is brought about by potentially higher costs of capital.
Before exploring the effects of the act on the cost of capital, it’s important to remember the components of the discounted cash flow (DCF) valuation model.
DCF value is a function of expected future net cash flows (the numerator) and present- value factors (the denominator) which are a function of the estimated cost of capital or the discount rate.
The act will generally increase the available net cash flows for businesses, increasing the numerator in a DCF model and thus leading to greater value. The recent run-up in stock prices(preceding their more recent crash) was generally driven by the expectation that net cash flows will increase, allowing for increased return of profits to shareholders (in the form of increased dividends and stock buybacks).
But the impact on the cost of capital is more complicated.
The cost of equity capital, in its simplest form, is typically expressed as a function of the risk-free rate, a market risk factor known as “beta”, and the equity risk premium, which is the equity return that investors demand to compensate them for investing in a diversified portfolio of large common stocks rather than investing in risk-free securities.
The Federal Reserve has started implementing what the financial press have coined “QExit,” a reduction in the Fed’s massive holdings of mortgage-backed securities and U.S. Treasury debt. Those holdings were designed to keep long-term interest rates down, thereby holding down the cost of equity capital. Now the Fed has determined that the economy is strong enough for interest rates to return to more normal levels, which will progressively lead to an increase in the cost of equity.
Beta risk is a function of business risk and financing risk. To the extent that business investment is financed by debt capital, beta risk increases. But that risk is partially mitigated by the tax deductibility of interest expense, reducing the true cost of interest expense. The act will increase the true interest cost by reducing the income tax savings due to the deduction of interest expense in calculating taxable income.
For example, assume a business has $10 million in interest expense. At a 37% income tax rate, the true cost of debt capital is $10 million x (1 – 37%) = $6.3 million. But at a 21% income tax rate, the true cost of interest is $10 million x (1 – 21%) = $7.9 million, increasing the true cost of debt capital by 25% and increasing the financial portion of beta risk.
However, one also needs to consider that a business may have some portion of their operations and profits earned in countries outside of the United States. That makes it important to consider all the relevant taxing jurisdictions in assessing a company’s global effective tax rate and consequent interest tax shield.
Finally, the weighted average or overall cost of capital to the business is a function of both the cost of equity capital and the cost of debt capital based on their proportionate amounts in the capital structure.
We’ve already seen that the combined actions of the Fed and Congress in enacting the new tax law will likely increase components of the cost of equity capital and increase the true cost of debt capital.
A newly-introduced provision will further reduce the value of interest tax shields, thereby further increasing the after-tax cost of debt. The act caps the ability by corporations to deduct interest expense above certain thresholds.
For businesses with revenues of more than $25 million, the interest deduction for years 2018 through 2021 is capped at 30% of “adjusted taxable income,” which is similar to earnings before interest expense, income taxes, depreciation, and amortization (EBITDA).
Thereafter the interest deduction is capped at 30% of “adjusted taxable income,” whose definition then switches to a measure similar to earnings before interest and income taxes (EBIT). These limitations will cause the cost of debt capital financing to increase even more.
Thus, for many larger businesses that have grown accustomed to relying on debt capital financing, their weighted average cost of capital will likely increase as result of The act.
These relationships, reflecting the tax act’s impact on beta risk and on the cost of debt capital, are becoming increasingly complex, affecting the ability to correctly estimate the cost of capital. Applying old formulas mechanically will likely prove unreliable as we move forward in this new tax regime.
Roger Grabowski is a managing director in the Duff & Phelps Valuation Advisory Services practice based in Chicago. He is co-author of Cost of Capital: Applications and Examples, 5th ed. (John Wiley & Sons, 2014).