The US Tax Cuts and Jobs Act (“TCJA”) passed by Congress on December 20, 2017, will impact forecasts of a company’s cash flow and thereby will likely impact the valuation of a company. One of the forecast elements impacted is the forecast of capital expenditures, depreciation and amortization.
The lowering of the C Corporation income tax rate from 35 percent to 21 percent will have a positive effect on the cash flow of affected corporations, all else held constant. With less cash going to pay taxes, more cash will be available for other uses, including capital expenditures (“capex”). This necessitates an increased scrutiny of a capex forecast, as recent historical expenditures may no longer be relevant as an indication of expected future expenditures.
The TCJA also allows for a first-year bonus depreciation of 100 percent — it was 50 percent prior to the TCJA — for certain qualified tangible property placed in service between September 28, 2017, and December 31, 2022, that has a depreciable life of up to 20 years. Generally, this bonus depreciation then declines in subsequent calendar years (exceptions for certain property):
The impact of these tax law changes will not be reflected in book basis depreciation calculations that appear in US GAAP financial statements; therefore, it is necessary for projections to be on a tax basis if they are being used for an income approach in a valuation of a business.
Business valuation analysts must be aware that the TCJA will cause the relationship between capex and depreciation to have an irregular pattern, and it will affect a much longer projection period than both company management and the valuator may be accustomed to preparing and analyzing. A longer forecast period is necessary due to the impact of timing differences on the present value of forecasted cash flows.
The always-important issue of normalizing capex and depreciation for the terminal period in a discounted cash flow model is further complicated by the depreciation provisions in the TCJA. A valuation analyst may address the issue by using a multi-stage model and capturing the depreciation provisions of the period 2018-2022 in the first stage, 2023-2027 in the second stage, and the length of the third stage being a function of the lives of the company’s assets. A valuator may also normalize the capex/depreciation for the terminal period in the year following the end of the projection period, and then separately adjust for the present value of the remaining TCJA induced capex/depreciation differences. The tax benefit of the amount not captured in the projection period would be calculated and then present valued over its remaining life at the terminal year. This amount would be added to the value of the company obtained from the discounted cash flow model. A valuator may use other multi-stage models customized for the type and lives of a company’s assets.
Overall considerations when forecasting capex/depreciation/amortization are as follows:
- Normalized future capex would typically be greater than depreciation in a projection for a growing company, to allow for inflationary growth in the replacement cost of fixed assets.
- Amortization has a limited life and should not be projected into perpetuity. The tax benefits of amortization subsequent to a projection period should be valued separately from the terminal value and added to the enterprise value.
- The tax benefit of the depreciation on long-lived assets subsequent to a projection period would be treated and calculated similarly as amortization.
- Due to the effects of provisions of the TCJA, valuation analysts must consider:
- Obtaining or preparing longer-term schedules of capex/depreciation forecasts;
- Building multi-stage models that account for the present value of changes in cash flow based on the depreciation provisions; and,
- Reviewing all management-supplied information for reasonableness and internal consistency, as other changes in the TCJA could also impact forecasted cash flows.
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