An Unexpected Boost to Value – From Income Taxes

In my last article, “What A Difference A Year Can Make – Interest Rates,” I discussed factors that are out of a business owners’ control that can impact the value of their businesses. I highlighted increasing interest rates and other economic factors, such as inflation (increasing costs for materials and labor), that can negatively impact the value of a business. On the other hand, positive impacts can also occur; for example, if your business is a Pennsylvania C Corporation it may have become more valuable in 2023.

Pennsylvania Governor Tom Wolf signed House Bill 1342 (H.B. 1342) into law in July 2022. One of the most important aspects of H.B. 1342 is that it established a phased in reduction of the Pennsylvania Corporate Net Income (PACNI) tax rate, which will be effective in the 2023 tax year. Through 2022 the PACNI tax rate has been 9.99%. However, beginning in 2023 the PACNI tax rate is reduced to 8.99%. In subsequent years, the PACNI tax will be reduced to 8.49% in 2024, 7.99% in 2025, 7.49% in 2026, 6.99% in 2027, 6.49% in 2028, 5.99% in 2029, 5.49% in 2030, and 4.99% for tax years beginning January 1, 2031 and years thereafter. The 5% decrease in PACNI results in future tax savings and an immediate increase in the value of a Pennsylvania C Corporation.

Any decrease in the effective tax rates (a combination of the Federal and State tax rates) of a business will have valuation implications. If you are using a Discounted Cash Flow methodology, the projection period will be longer to account for the time until the effective tax rate has stabilized. As the tax rate changes the Weighted Average Cost of Capital (WACC) will change each year if the Company has debt. The present value factor used to discount the cash flows each year should be tied to the WACC for that year and the applicable effective tax rate for that year.

I have estimated the effective tax rates for Pennsylvania C Corporations to be 28.10% for 2023, 27.71% for 2024, 27.31% for 2025, 26.92% for 2026, 26.52% for 2027, 26.13% for 2028, 25.73% for 2029, 25.34% for 2030, and 24.94% for 2031. I have based the tax rate calculations on the Tax Cuts and Jobs Act of 2017 and PA H.B. 1342.

To explore the potential impact of a decreasing effective tax rate, I ran two simplified valuation scenarios using the same WACC assumptions of 20% debt / 80% equity, a 22% cost of equity and a 7% cost of debt. I used identical inputs of annual earnings before tax of $1 Million, no depreciation, no capital expenditures, and no incremental working capital requirements. The only difference in the two scenarios is the change in the effective income tax rates and the resulting impact on the WACC. The first scenario used a static 29% tax rate (a reasonable assumption prior to the impact of H.B. 1342) and the second scenario used the effective tax rates calculated above. The result of the first scenario is a calculated enterprise value (the value of both debt and equity) of $4,158,311. The second scenario with decreasing effective tax rates resulted in an enterprise value of $4,293,082, a 3.24% increase in value. The only difference in the two scenarios is the decreasing effective tax rates. In this case, a change in tax rates results in an increase in the value of a business operating as a Pennsylvania C Corporation.

Visit our webpage for more information on McKonly & Asbury’s Business Valuation Services. Should you have questions about the impact of increasing interest rates, or business valuations in general, don’t hesitate to contact T. Eric Blocher CPA, ASA, CVA.