Tax Law Changes Affect the Cost of Capital

The Tax Cuts and Jobs Act (TCJA) has altered the cost of capital for many companies. So, if your company has historically used, say, a 14% “hurdle rate” to evaluate investment decisions, you might need to adjust that figure going forward.

For example, in situations where a business uses its tax savings from the TCJA to pay off debt or repurchase outstanding stock, it could affect the company’s expected capital structure. That is, its blend of debt and equity financing.

Companies that transition to more equity financing (by paying down debt) could potentially increase the overall cost of capital. That’s because the pre-tax cost of debt is generally less expensive than the pre-tax cost of equity. Those that transition to more debt financing (by buying back stock) would likely reduce their overall cost of capital.

The TJCA also limits interest expense deductions for larger companies to 30% of qualified business income. This limitation could increase the cost of debt — because less interest expense would be tax deductible. However, companies with average annual gross receipts of $25 million or less for the three previous tax years are exempt from this limitation. The rules also allow certain real estate and farming entities to elect out of the limitation rules.

For more information about how the TCJA affects your company’s cost of capital, contact a business valuation professional.