A couple of months ago, I had a good chat with two friends on the discount rate.
One graduated with a PhD in finance and has finance experience in the private sector. The other holds a master’s in economics and works with a government agency, overseeing investments. Here is a summary of our conversion:
The government recently announced a cut in corporate tax from 30 to 23 per cent. It seems obvious that the cut will increase shareholders’ wealth. This is because the free cash flows of a company are generally shared by three parties: the shareholders, the debt holders and the government through tax collection. If the government decides to reduce tax while the debt holder demands the same, then shareholders will benefit.
Is this understanding totally correct?
Let’s take a closer look.
From the valuation model using the discounted cash flow approach, the free cash flows of a firm in future years are discounted to present value, which represents the value of a firm. Its outstanding debts are then deducted from the firm’s value to derive the equity value or share price.
When the tax rate is cut, the free cash flows to a firm will increase, and hence so will the equity value or share price. This is true for profitable companies that pay tax and have no debt. Simple put, the government gives back a portion of tax to the shareholders.
However, will the change in the corporate tax rate have any impact on the discount rate, which is used to discount the free cash flows of companies that have debt (leveraged companies)?
For a leveraged company, the discount rate (WACC) is used, it being the average rate of return required by a shareholder and a debt holder. If the free cash flows to a firm increase and the discount rate also increases, then the impact on the share price may not be as straightforward as we think.
Looking at the CAPM (capital asset pricing model) and the WACC (weighted average cost of capital) formula, there is a corporate tax factor (t) in the calculation of WACC. If the tax reduces from 30 to 23 per cent, the portion of Kd [Kd (D) x (1-t)] will increase and so does the WACC assuming the Ke x (E) portion remains unchanged.
Equity Value (share price) = Firm Value – Debt
WACC = Ke x (E) + [Kd x (D) x (1-t)]
CAPM: Ke = Rf + Beta x (Rm – Rf)
Ke = Cost of equity
Kd = Cost of debt
E = Equity portion
D = Debt portion
t = Corporate tax rate
Beta = Risk of particular stock
Rm = Market return
Rf = Risk free rate
Now there is a situation where both cash flows to a firm and the discount rate (WACC) increase as a result of the tax cut. The valuation result depends on which factor, increase in cash flow or WACC, has a greater impact.
In addition, the tax cut may also impact Ke in CAPM because of the change in Beta for leveraged companies. The Beta in CAPM is the risk factor of a particular stock relative to a diversified portfolio of investment and it is associated with two key factors: business risk and financial risk (the leverage). If the equity value is expected to increase when the tax rate is cut while debt remains the same, the debt-to-equity ratio (the leverage) will decline. As a result, the risk or Beta will be lower. Basically, the risk is expected lower because of lower leverage. The decline in Beta will then lower the Ke in the CAPM calculation.
There is an argument over whether the tax cut will change the leverage. Well, this depends on how a firm chooses to leverage. If the equity value increases because of the tax cut, the leverage of the firm will decline which consequently reduces Beta. But if the firm decides to maintain the same leverage by borrowing more, the Beta will not change and neither will the Ke.
Now there are two alternatives: 1) Ke stays the same but Kd increases, and 2) Ke decreases while Kd increases. The two scenarios including higher cash flows may result in different valuations, and that depends on which factor has a greater impact to the valuation model and share price. So the tax cut may not have the direct positive impact to the share price of leveraged companies that many people assume.
Thavee Thaveesangsakulthai is a partner in Financial Advisory Services at Deloitte Touche Tohmatsu Jaiyos.