Content uploaded by Gilbert Matthews
Author content
All content in this area was uploaded by Gilbert Matthews on Apr 02, 2020
Content may be subject to copyright.
The Impact of TCJA on Cost
of Capital
ASA Ask the Experts Webinar
March 12, 2018
© 2018 American Society of Appraisers 1
Introduction to the Panel
Jay Fishman,
FASA
Financial Research
Associates
Bala Cynwyd, PA
jfishman@
finresearch.com
Roger Grabowski,
FASA
Duff & Phelps
Chicago, IL
roger.grabowski@
duffandphelps.com
Gil Matthews,
CFA
Sutter Securities
San Francisco, CA
gil@suttersf.com
Jeff Tarbell,
ASA
Houlihan Lokey
San Francisco, CA
jtarbell@hl.com
Depreciation Issues
© 2018 American Society of Appraisers 25
Accelerated Depreciation
§For qualified tangible property (and certain computer
software) placed in service between Sept. 28, 2017 and Dec.
31, 2022 that has a depreciable life of up to 20 years, the
first-year bonus depreciation percentage is 100% (up from
50%)
•This accelerated depreciation will not be permitted under many
states’ tax laws
§This 100% deduction is allowed for both new and used
qualifying property
© 2018 American Society of Appraisers 26
Accelerated Depreciation (cont.)
§In subsequent years, the bonus depreciation will be:
•2023 : 80%
•2024 : 60%
•2025 : 40%
•2026 : 20%
§For certain property with longer production periods, the 100%
write-off extends through 2023 and scales down from 2024
through 2027
© 2018 American Society of Appraisers 27
Management Projections of CapEx and Depreciation
§The work of the valuator is simplified if management supplies
adequate schedules as to capex and depreciation for the
projection period
§It is even more helpful if longer-term schedules are made
available
§When management has supplied information, the valuator
should review the data for reasonableness and internal
consistency
© 2018 American Society of Appraisers 28
GAAP Financials are Insufficient for DCF Calculations
§The impact of some of the tax changes will not be shown in
GAAP income statements
§For example, depreciation will be based on GAAP rules and
not on the accelerated schedule permitted for tax purposes
§Therefore, the cash savings will not be directly shown
§It will be necessary to ask clients for projections not only on a
GAAP basis but also on a tax basis
•GAAP financials are appropriate for the market method but usually
will not suffice for the income method
© 2018 American Society of Appraisers 29
Changes to the CapEx/Depreciation Relationship
§The table below shows the impact of accelerated
depreciation, assuming normal straight-line ten-year
depreciation and 3% growth in capex
© 2018 American Society of Appraisers 30
2016 2017 2018 2019 2020 2021 2022
Depreciation 841 1,103 1,845 1,798 1,750 1,700 1,649
CapEx 971 1,000 1,030 1,061 1,093 1,126 1,159
2023 2024 2025 2026 2027 2028 2029
Depreciation 1,369 1,099 837 586 358 457 598
CapEx 1,194 1,230 1,267 1,305 1,344 1,384 1,426
2030 2031 2032 2033 2034 2035 2036
Depreciation 742 891 1,045 1,191 1,317 1,423 1,505
CapEx 1,469 1,513 1,558 1,605 1,653 1,702 1,754
Abnormal Capex/Depreciation Ratios
86.6%
110.3%
179.2%
169.5%
160.2%
151.1%
142.3%
114.7%
89.3%
66.1%
44.9%
26.7%
33.0%
41.9%
50.5% 58.9%
67.1%
74.2%
79.7%
83.6%
85.8% 86.6%
86.6%
0%
25%
50%
75%
100%
125%
150%
175%
200%
2016 2018 2020 2022 2024 2026 2028 2030 2032 2034 2036
2038
Depreciation as % of CapEx
10-Year Straight Line Depreciation, 3% Growth
© 2018 American Society of Appraisers 31
Abnormal Capex/Depreciation Ratios (cont.)
§With 10-year depreciation, the relationship between capex
and depreciation does not normalize until 2037
§If assets are depreciated over a 15-year period, the
relationship of depreciation to capex does not normalize until
2042
© 2018 American Society of Appraisers 32
Normalizing for Terminal Value
§For terminal value calculations, capex and depreciation
should be normalized
§The ability of companies to write off capital expenditures in
the first year rather than depreciating them materially
complicates the treatment of capex/depreciation in
calculating terminal value
© 2018 American Society of Appraisers 33
Adjusting for Abnormal Capex/Depreciation Ratios
§The Gordon growth model necessarily assumes that FCF in
the base year is normalized and does not include non-
recurrent or limited-life items
§The new tax law will cause depreciation to follow an irregular
pattern for a period much longer than the length of most
management projections
§The basic issue here is the impact of timing differences on
present value
© 2018 American Society of Appraisers 34
Calculating Terminal Value
§There are various ways in which this can be addressed
§One approach is to use a multi-stage model. E.g.:
•A second stage for declining depreciation
•A third stage as it increases
•A final stage when the normal capex/depreciation relationship is restored
§Because of the scale-down in accelerated depreciation from 80%
in 2023 to none in 2027, the second stage should run through
2027, the year in which depreciation is at its low point
§The length of the third stage would be a function of the
depreciation period for the company’s assets
© 2018 American Society of Appraisers 35
Calculating Terminal Value (cont.)
§Another approach is to calculate terminal value based on
normalized data and then to adjust for the present-value of
the abnormal capex/depreciation differences
§A third alternative is to use a two-stage model through 2027,
to compute terminal value based on normalized 2028 data,
then to adjust for the present value of the remaining
capex/depreciation differences
•If the company’s fiscal year is not a calendar year, the second stage
should end with the 2027/28 fiscal year, so that the second stage will
include the entire period of declining depreciation
© 2018 American Society of Appraisers 36
An Example
§Assume we have management projections though 2022
§Let’s look at an example of calculating terminal value using the third
alternative, using the following assumptions:
•Projected revenues in 2022 = 200
•Growth rate = 5% from 2022 to 2027, 3% thereafter
•Discount rate = 12%
•EBITD [not EBITDA] margin = 20%
•No interest
•Capex = 10, growing at growth rate
•Accelerated depreciation per new tax law
•Normalized depreciation = 10-year straight line
•State income tax = 6% = 4.74% net of federal tax*
•Δ working capital = 5% of Δ revenues
•Amortization = 5 per year through mid-2024
–*Assuming the state’s tax law follows federal law; many states do not
© 2018 American Society of Appraisers 37
Stage 2
Present Value of FCFs, 2023–2027
2022 2023 2024 2025 2026 2027
Sales $200.0 $210.0 $220.5 $231.5 $243.1 $255.3
EBITDA 45.0 47.0 46.6 46.3 48.6 51.1
Depreciation 14.2 12.0 9.8 7.6 5.5 3.4
Amortization 5.0 5.0 2.5 0.0 0.0 0.0
EBIT 25.8 30.0 34.3 38.7 43.2 47.6
Tax at 25.74% 6.6 7.7 8.8 10.0 11.1 12.3
Net income 19.1 22.2 25.4 28.7 32.1 35.4
Capital expenditures (10.0) (10.5) (11.0) (11.6) (12.2) (12.8)
Depreciation 14.2 12.0 9.8 7.6 5.5 3.4
Amortization 5.0 5.0 2.5 0.0 0.0 0.0
Change in working capital (1.0) (1.0) (1.1) (1.1) (1.2) (1.2)
Free cash flow 27.4 27.8 25.7 23.7 24.2 24.8
Discount Factor @ 12% 0.6005 0.5362 0.4787 0.4274 0.3816 0.3407
Present Value 14.9 12.3 10.1 9.2 8.5
Sum, 2023-2027 $46.6
© 2018 American Society of Appraisers 38
Normalized FCF for Growth Model
§Now we determine the normalized FCF for 2027 & 2028
§As shown earlier, normalized depreciation is 86.6% of capex
Normalized DCF for Growth Model
2027 2028
Sales $255.3 $262.9
EBITDA 51.1 52.6
Depreciation (normalized) 11.1 11.4
Amortization 0.0 0.0
EBIT 40.0 41.2
Tax @ 25.74% 10.3 10.6
Net income 29.7 30.6
Capital expenditures (12.8) (13.1)
Change in working capital (1.2) (0.8)
Free cash flow $26.8 $28.1
© 2018 American Society of Appraisers 39
PV of Difference between Actual and Normalized Depreciation
§We can then compare annual depreciation based on the tax law with normalized
depreciation and calculate the present value (net of tax) of the differences
Present Value of Under-Depreciation
2028 2029 2030 2031 2032 2033 2034 2035 2036
Sales
$262.9
$270.8
$278.9
$287.3
$295.9
$304.8
$313.9
$323.4
$333.1
EBITDA 52.6 54.2 55.8 57.5 59.2 61.0 62.8 64.7 66.6
Depreciation for tax
purposes 4.3 5.7 7.0 8.5 9.9 11.3 12.5 13.5 14.3
Depreciation normalized 11.4 11.7 12.1 12.4 12.8 13.2 13.6 14.0 14.4
Difference (7.0) (6.0) (5.0) (4.0) (2.9) (1.9) (1.1) (0.5) (0.1)
Difference net of 25.74% tax (5.2) (4.5) (3.7) (2.9) (2.1) (1.4) (0.8) (0.4) (0.1)
Capital expenditures (13.1) (13.5) (13.9) (14.4) (14.8) (15.2) (15.7) (16.2) (16.7)
Change in working capital (0.8) (0.8) (0.8) (0.8) (0.9) (0.9) (0.9) (0.9) (1.0)
Free cash flow 1.8 3.1 4.4 5.7 7.1 8.4 9.5 10.4 11.1
Discount Factor @ 12% 0.3042 0.2716 0.2425 0.2165 0.1933 0.1726 0.1541 0.1376 0.1229
Present Value $(1.59) $(1.22) $(0.91) $(0.64) $(0.41) $(0.24) $(0.12) $(0.05) $(0.01)
Sum of Present Values of Under-Depreciation, 2028-2036 $(5.2)
© 2018 American Society of Appraisers 40
Application of Other Approaches
§This model can be used in three stages by treating 2028-
2036 as stage 3 and calculating terminal value with a growth
model based on 2037
•In that case, the adjustment for over-depreciation would not be
needed since it would be subsumed that the intermediate stages
§If terminal value is calculated with a growth model based on
2023, a calculation of the present value of over-depreciation
in the early years and subsequent under-depreciation would
need to be performed
© 2018 American Society of Appraisers 41
Companies May Accelerate Capex
§Our example assumes that capex will grow steadily
§In practice, companies may accelerate capex to take
advantage of accelerated depreciation
§However, given the gradual 20% annual decrease from 2022
through 2027, the impact of accelerated capex is unlikely to
be material
•Valuators should ascertain management’s plans for capex as part of
their due diligence
© 2018 American Society of Appraisers 42