How does Valuation of a company change if tax rate increase? a. Increases b. Decreases c. No change

Question

When taxes increase, the cash flow from the company decreases, and that will decrease the company valuation.

Answer 1

The two main methods for valuating companies are the fundamental valuation approach and the relative valuation approach

The fundamental valuation approach is based on the company risk and discounted cash flow. Company cash flow is discounted on a risk affected discount rate. When taxes increase; the cash flow will decrease and the valuation of the company decrease.

In the relative valuation approach, we use multiples such as P/E ratio (multiple) and other ratios like the EV/ EBITDA. Lets concentrate at the EV/EBITDA ratio to understand how valuation of a company is affected by changes in taxes using the relative valuation approach.

EV stands for Enterprise value, which is the value of the corporation minus cash and cash equivalents.

EV = Market capitalization + value of debt+ minority interest+ preferred shares- cash and cash equivalents. 

The way we use EV/ EBITDA multiple is that we find the EV/ EBITDA multiple for one company (better take the average of the multiple companies) then multiply it with the EBITDA for a company, that is comparable to the first company, with an unknown Enterprise value. This will allow us to find the EV value of the second company.   

Let’s take the following example:

ABC company is listed on a stock exchange, its enterprise value is $500M, calculated using the above formula, its EBITDA is $20M. The EBITDA was taken from the company financial statements. XYZ company is a comparable company, in the same industry and the same country, etc., its EBITDA is $10M, what is the Enterprise value of XYZ using the relative valuation approach?

First step: We find the EV/ EBITDA multiple for ABC

                  $500M/$20M= 25X. 

Step two: We multiply the XYZ EBITDA with the multiple we found in the last step.

25*$10=$250M

Notice that the EV value of XYZ was extracted from the EV value and multiple of ABC that already reflect the taxes in ABC jurisdiction and which is the same tax jurisdiction as of XYZ, and that means that the EV calculated for XYZ already reflect taxes since taxes is reflected in the ABC EV value. If the tax rate decrease, let’s assume to zero, then investors will value ABC stock more and push its market capitalization higher; reflecting their value of the increased expected cash flow of ABC company. When the zero tax multiple EV/EBIT calculated for ABC is multiplied with the XYZ EBITDA, the new value of XYZ will reflect the new zero tax rate and the value will increase. Now we learned how decrease in taxes will increase the valuation, so when taxes increase the opposite will happen, the valuation will decrease.

Answer 2

Hello,

The best way of thinking about this question is to understand how a valuation is formed.

One of the most common ways of valuing a company is based off of the discounted cash flow model or based off of its EBITDA (earnings before income tax and depreciation).

Depending on which model you use will depend on if a change in taxes will change its value. If you are using after tax metrics for your model an increase in taxes will decrease the value of the company due to a decrease in the after tax cash flows used in the model. In this case the answer would be (B. Decrease)

If you are using a pretax or operating income metric such as EBIT or EBITDA in your valuation, by definition, a change in taxes will have no affect on the value of the pretax income and as a result the business valuation. In this case the answer would be (C. No Change)

B vs C would depend on the class or situation you're in.

Hope that helps