Are you sure you consider taxes correctly?
“Taxes? My
company is far away from breaking even. Taxes don’t matter to me.” This is a
statement often heard from entrepreneurs. The fact that taxes might only be due
in the far future – and are therefore heavily discounted – and that
even then the accumulated losses can first be offset against profits lets many
think that the effect of taxes is virtually negligible.
Unfortunately,
this is downright wrong. If the company is to have a positive value, then the revenues
must at least exceed its expenses over the whole lifetime. These exceeding
revenues will ultimately make up the value. At that point all accumulated
losses will be offset and the exceeding revenues will all be fully taxed. Consequently,
if the company is to have a positive value, then the pretax value is at least
reduced by the amount of the tax rate. The value reducing effect of the tax
rate is actually even more severe than that, as we will see:
First the
accumulated losses do not accrete over time, i.e. they can only be offset one
to one against future earnings, and the time value of the investments is
therefore lost. Second, the accumulated losses can only be offset if the
company becomes profitable; in many cases this is not a certainty. If the
company does not reach profitability the tax value of the accumulated losses
– the tax assets – are lost. These two reasons imply that the
pretax value of a company is reduced by more than the tax rate.
Usually, all valuations are performed on a riskadjusted basis, i.e. all cash flows are multiplied with their probability. Assume a project has only a 25% chance to reach the market. Consequently, we only account for the sales revenues at 25% of their nominal values. Typically, the calculation of taxes is then made on a riskadjusted basis as well. In table 1 the valuation of an R&D project with two twoyear phases of 50% success rate each and a fouryear commercialisation period is displayed. The tax rate is 20%, the discount rate is 10%. We have encountered the displayed method several times in valuation and analyst reports.
Table 1: Standard
Valuation of R&D Project
Year

1

2

3

4

5

6

7

8

Phase

Pilot

Pilot

Pivotal

Pivotal

Market

Market

Market

Market

Probability

100%

100%

50%

50%

25%

25%

25%

25%

Cash Flows (CF)

3

3

15

15

20

40

50

40

rCF

3

3

7.5

7.5

5

10

12.5

10

rAcc Losses

3

6

13.5

21

16

6

0

0

rTaxes

0

0

0

0

0

0

1.3

2

Discount

100%

91%

83%

75%

68%

62%

56%

51%

rpCF

3.0

2.7

6.2

5.6

3.4

6.2

6.3

4.1

rNPV

2.5








In the example the cash flows are adjusted to their probability (rCF: risk adjusted cash flows). Based on these the accumulated losses at yearend have been calculated. According to this calculation the company only has to pay taxes in year 7 (partially) and 8. The calculated value is USD 2.5 Mio. Without the tax considerations the value would be USD 4.3 Mio.
Closer look at
the standard method
Analysing the
positive scenario when the project reaches the market we notice that the
company needs to spend USD 36 Mio to get there. These can be carried forward
but are already used up after Q1 of year 6. This is not in line with the
calculations that say we only have to start pay taxes in year 7. So what happened?
In the standard method we assumed that the accumulated losses are riskadjusted (we used the riskadjusted cash flows to compute them). But this way we account for the first phase 100% of the expenses and for the second phase just 50% of the expenses. But then we offset them against 25% of the revenues. In fact, we overstate the first phase costs by a factor 4 and the second phase costs by a factor 2 in the accumulated losses. The riskadjusted accumulated losses of USD 21 Mio require USD 84 Mio sales to be fully offset. In reality the company spends at most USD 36 Mio. The standard method therefore overestimates the taxreducing effect of the accumulated losses.
Correct valuation
In reality the accumulated losses are offset against the revenues as they occur, not against the riskadjusted revenues. Table 2 displays the valuation considering taxes correctly.
Table 2: Correct
Valuation of R&D Project
Year

1

2

3

4

5

6

7

8

Phase

Pilot

Pilot

Pivotal

Pivotal

Market

Market

Market

Market

Probability

100%

100%

50%

50%

25%

25%

25%

25%

Cash Flows (CF)

3

3

15

15

20

40

50

40

rCF

3

3

7.5

7.5

5

10

12.5

10

Acc Losses

3

6

21

36

16

0

0

0

Taxes

0

0

0

0

0

4.8

10

8

rTaxes

0

0

0

0

0

1.2

2.5

2

Discount

100%

91%

83%

75%

68%

62%

56%

51%

rpCF

3.0

2.7

6.2

5.6

3.4

5.5

5.6

4.1

rNPV

1.1








A valuation that
correctly considers the offsetting of accumulated losses with earnings yields a
value of USD 1.1 Mio. A tax rate of 20% hence reduced the value by an
impressing 75%.
Table 3: Different
Valuations at 20% Tax

Value
(USD Mio)

Value
reduction

PreTax
Valuation

4.3

0%

Standard
Method

2.5

41%

Correct
Valuation

1.1

75%

The above
displayed valuation is based on the assumption that in case of failure the tax
assets are lost. This is not necessarily true. The company could be sold as a
shell company including the tax assets. But usually this is linked to some
requirements by tax authorities and often the tax assets cannot be realised.
Company with several projects
If the company
has other projects, then the accumulated losses are calculated on a consolidated
basis. If the company reaches profitability, albeit it is only because of one
project, it can use the accumulated losses from all projects. The exact valuation
of such multiproject companies – which is the normal case – is
quite cumbersome. Assume the previous company, but with two projects of the
same kind. It is possible that the company reaches profitability with either
one project or with both. If it is with one project, then it the fate of the
other project still matters (i.e. whether it failed in the pilot or in the pivotal
phase) because of the accumulated losses. Table 4 contains a list of the
possible scenarios that have to be analysed and probability weighted.
Table 4: Scenarios for a
2Project Company

Project
1

Project
2

1

Market

Market

2

Market

Pivotal

3

Market

Pilot

4

Pivotal

Market

5

Pilot

Market

Obviously, it is
also possible that both projects fail, but these scenarios are uninteresting
from a tax perspective.
Conclusion
The example makes
clear that a correct consideration of taxes is far more difficult than the
relatively simple problem setting. Although the example chosen might be quite
extreme in terms of value reduction, we often encounter differences between
standard and correct method in the order of 20%.