How Changes in Tax Rates Impact Private Equity Valuation

The relationship between tax rates and the valuation of private equity investments is a critical factor that every professional in the field must understand. As Aswath Damodaran so aptly puts it, the tax rate significantly influences the enterprise value (EV) of a company. In this article, we will delve into the implications of tax rate changes on the valuation of private equity investments, focusing on how such changes affect free cash flow to the firm (FCFF), enterprise value (EV), and free cash flow to equity (FCFE).

Understanding the Impact of Higher Tax Rates on FCFF

When the tax rate increases, the free cash flow to the firm (FCFF) will decrease, or at best, stay constant if the company is a loss-making entity primarily due to operating losses or high interest charges. The increase in the corporate tax rate (CIT) often comes with rises in capital gain and dividend taxes as well. This has a direct impact on the FCFF calculation, where a portion of after-tax profits is paid out in taxes.

Let's consider a critical scenario where the tax rate is 100%, meaning all income is paid in taxes. If this condition is met, why would anyone invest in a company that is paying out all of its income in taxes? In such a case, the enterprise value would decrease because the value received by investors would be significantly reduced due to the increased tax burden.

Analyzing the Implications on Debt Value and Cost of Debt

When the tax rate increases, the interest charge stays the same. However, the cost of debt might increase due to higher taxes, which can lead to an increase in the weight of debt on the balance sheet. In this context, the value of debt would also stay constant if the cost of debt does not change

Mathematically, the enterprise value (EV) is the sum of the debt and equity values. Since the equity value will decrease due to the increase in the cost of equity (due to higher taxes), the overall enterprise value will decrease as well. The formula for enterprise value can be expressed as:

EV Debt * (1 - Tax Rate) Equity Value

Given that equity value is directly impacted by the cost of equity, which increases with higher taxes, and the debt value remains constant, the total enterprise value decreases. This is because the higher taxes reduce the after-tax benefits from the corporate activities, thus reducing the overall value of the firm.

Considering the Impact on Equity Value and Cost of Equity

When the tax rate increases, the free cash flow to equity (FCFE) will decrease. If the cost of equity increases due to higher taxes, the equity value will decrease. This increase in the cost of equity can be attributed to the higher risk associated with holding equity in a highly taxed company.

Addressing the Interviewer’s Context

The assumption behind the interviewer's question might have been based on a simplified mechanical application of the WACC formula for companies that do not pay taxes. In such a scenario, the FCFF would remain constant, and the enterprise value would still be affected by the changes in the cost of capital, which includes the cost of debt and equity.

The cost of debt is likely to increase by not only because of the higher interest rates but also due to higher perceived risk by lenders. On the other hand, the cost of equity might increase due to the reduction in the net returns to shareholders after tax.

Conclusion

Changes in tax rates have a direct and significant impact on private equity valuation. They can lead to a decrease in enterprise value by reducing the free cash flows to the firm and equity, ultimately affecting the overall investment attractiveness. Understanding these dynamics is crucial for private equity professionals and investors to make informed decisions.

Keywords: Private Equity, Tax Rate, Valuation