The 2017 tax reform bill introduced sweeping changes to the corporate tax landscape, most notably reducing the corporate marginal tax rate from 35% to 21% and altering the treatment of interest expense as a tax shield. These changes have created both opportunities and unique challenges for corporate managers and finance professionals, shifting both tax planning strategies and core valuation methods.
This article explores the implications of these changes for traditional valuation techniques such as discounted cash flow (DCF) and EBITDA multiple methodologies, highlighting how they affect corporate valuation and decision-making in today’s tax environment.
Key Changes in Corporate Tax Policy
On December 27, 2017, the tax reform bill was signed into law, representing one of the most significant overhauls of U.S. corporate tax policy in decades. Prior to the reform, U.S. corporations faced one of the highest marginal tax rates globally at 35%. The tax reform lowered that rate to 21%, while also granting a 20% tax deduction for qualified pass-through entities like S-Corps and LLCs.
The reform freed billions of dollars for U.S. companies, sparking debates about how these new savings would be deployed. Headlines documented wide-ranging strategies—from one-time employee bonuses (e.g., Chipotle) to expanded capital expenditures (e.g., AT&T pledged an additional $1 billion investment for 2018). However, beyond boosting corporate spending, the tax reform has introduced structural changes, including a cap on interest deductibility, which is already reshaping corporate finance strategies across industries.
The New Interest Deductibility Framework
For decades, debt financing largely benefited from the ability to fully deduct interest expenses from taxable income, driving annual growth in debt issuance. However, the tax reform law significantly changes this landscape.
Key Aspects of Interest Deductibility Cap:
- Interest expense is now deductible only up to 30% of EBITDA through 2021.
- Starting in 2022, the cap becomes stricter, applying to 30% of EBIT, which excludes depreciation and amortization.
These limitations disrupt how corporations have traditionally used debt in their capital structures, with profound implications for net income, cash flow, the weighted average cost of capital (WACC), and overall valuations.
How Interest Deduction Limits Affect Net Income and Cash Flow
The cap on interest deductions directly impacts net income and cash flows, particularly in industries with high leverage or low margins, such as healthcare, energy, and pharmaceuticals. Research by economists John Graham and Young Jun Song from Duke University reveals that the average U.S. corporation will lose 41% of its interest deductions under the new law.
Case Study: Understanding the Impact
Let’s examine how the new tax regime affects a hypothetical company, “Company A”:
- EBITDA: $1 million
- Debt Outstanding: $10 million
- Interest Rate: 6%
Under the old tax regime, Company A could fully deduct $600,000 in interest expenses, leading to a taxable income of $400,000 and taxes of $140,000 at the 35% rate, resulting in net income of $260,000.
With the new rules:
- Interest deductions are capped at 30% of EBITDA ($300,000).
- Taxable income increases, leading to taxes of $147,000 (at the 21% rate) and net income of $253,000.
- Effective Tax Rate: Increases from 35% to 36.75%, despite the lower statutory rate.
Thus, while the corporate tax rate has been slashed, businesses with high debt levels may face elevated effective tax rates due to the new deductibility limitations.
Valuation Implications: Rethinking the EBITDA Multiple
For years, the enterprise value-to-EBITDA (EV/EBITDA) multiple has been a cornerstone of corporate valuation. Its popularity derives from EBITDA’s traditional role as a proxy for operating cash flow. However, the tax reform complicates this approach, particularly for highly levered companies.
Challenges with EBITDA Post-Reform
The limitation on interest deductibility weakens EBITDA’s reliability as a cash flow proxy because:
- Variability between EBITDA and true free cash flow (FCF) is amplified for highly leveraged or low-margin firms.
- Comps-based valuations (comparable companies or transactions) may become distorted as the tax law alters effective profitability across industries.
For example, companies close to the 30% EBITDA cap might experience disproportionate declines in FCF due to non-deductible interest expenses, skewing their valuation. Conversely, firms with low leverage or high EBITDA relative to debt benefit more than ever from deducting all interest expenses.
Marginal vs. Effective Tax Rates in Valuation
The debate over whether to use a company’s marginal tax rate (21%) or effective tax rate (variable) in valuation calculations remains critical. While effective tax rates reflect actual taxes paid, they are susceptible to year-over-year fluctuations driven by accounting adjustments. For consistency, the marginal tax rate is generally preferred in discounting cash flows and calculating free cash flow, especially as leverage levels shift over time.
Impact on WACC and Valuation Techniques
The tax reform not only alters FCF but also affects the weighted average cost of capital (WACC), a critical input for DCF valuations. WACC reflects the cost of debt and equity capital, weighted by their proportion in a company’s capital structure. With the new tax law, both components are impacted:
- Cost of Debt:
Previously, full interest deductibility lowered the after-tax cost of debt. Under the new regime, companies with limited deductions experience a higher after-tax cost of debt.- Example: For Company A, the cost of debt rises from 3.9% (pre-reform) to 5.4% (post-reform), assuming partial deductibility of interest.
- Cost of Equity:
The reduction in tax shields indirectly raises equity holders’ risk, increasing relevered betas and the cost of equity.
With both costs rising, WACC increases, reducing the present value of cash flows in DCF models and lowering intrinsic valuations.
Strategies to Navigate the New Valuation Landscape
Corporate managers and finance professionals must adapt valuation methodologies to accurately reflect the new tax environment. Key considerations include:
- Adjusting WACC Annually:
Treat WACC as dynamic, recalculating it every year based on changes in cash flows, leverage, and interest deductibility thresholds. - Scenario Analysis for Interest Caps:
Evaluate scenarios where the company improves operating income to surpass the 30% EBITDA or EBIT interest cap, reducing the immediate tax burden. - Enhanced Sensitivity Analyses:
Given EBITDA’s diminished reliability, analysts should stress-test valuations under varying scenarios of leverage and effective tax rates. - Balance Sheet Discipline:
Companies must reconsider debt-heavy capital structures, aligning leverage levels with tax benefits under the new deductibility limits.
Conclusion: A New Era for Corporate Valuation
The 2017 tax reform has introduced profound shifts in tax policy, reshaping how debt, cash flow, and returns are considered in valuation models. For finance professionals, understanding these changes is crucial to making sound decisions regarding corporate structure, investment, and value creation. While there is no universal solution, firms that holistically reevaluate their capital structures and apply dynamic valuation methodologies are best positioned to thrive in this new environment.
As WACC and free cash flow calculations evolve, so too must the strategies used to maximize shareholder value. Analysts, portfolio managers, and corporate leaders must adapt quickly—because in today’s rapidly changing financial landscape, agility and knowledge are more critical than ever.