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Experienced financial experts can probably only smile at such a question. After all, we associate a reduction in equity with incurring a loss on operational activities or recognising an impairment loss for some assets; things are not going well, and when things are not gong well, it is hard to suppose that the value of our business would be going up.

But ... never say never...

The tax reform introduced by the Trump administration on 1 January 2018 decreased the corporate income tax rate from 35% to 21%. What connection does this have with a decrease in equity? As it turns out, quite a lot, and the path leads through the mysterious deferred tax asset. In short, this mysterious asset is, algebraically, counted as already recognised accounting costs that can be used for tax purposes in future periods multiplied by the rate of corporate income tax. Added to this are also tax losses to be used in future years.

During the financial crisis of 2007-2009, many global companies suffered enormous tax losses, and these tax losses built up can be settled over time, in accordance with the tax legislation of a given country. This applies to American businesses in particular. As a consequence of the decrease in the corporate tax rate in the United States, those American entities that have accumulated tax losses in previous years and recognise deferred tax assets will have to effect a partial write-downs of these assets.

And so, according to the February issue of Accounting and Business: International Edition, of large American companies, the Citigroup firm has to reduce deferred tax assets in the amount of US$16billion dollars (PLN58.7billion; values in PLN in accordance with the average NBP exchange rate as at 23 May 2018 - US$/PLN 3.6693), Goldman Sachs - US$5bn (PLN18.3bn), Bank of America - US$3bn (PLN11.0bn), American Express – US$2.4bn (PLN8.8bn); Shell – US$2bn (PLN7.3bn); Barclays US$1.3bn (PLN4.8bn), and Morgan Stanley US$1.25bn (PLN4.6bn). For comparison, the sum of equity of the Polish banking sector at the end of 2017 amounted to PLN204.3bn, whereas the net sum of financial results of the Polish banks in 2017 was at a level of PLN13.6bn.

Inarguably, the immediate effect of the introduction of the reduced tax rate will be a decrease of equity. In this specific case, will it translate into an increase of the value of the business? We are dealing with two effects: a reduction of financial benefits due to decreased future net tax loss settlements, and also an increase of financial benefits related to the lower taxation of profits from operational activities. The answer is, therefore, simple – if the latter effect is stronger than the former, we should see an increase in the value of the business. In strictly financial terms – if the present value of the product of the tax rate reduction (in this case 14%) and the forecast operating profits is greater than the present value of the product of the tax rate reduction (14%) and future settlements of accumulated tax losses then the value of the company should increase.

To be clear, there is also one effect of reducing the tax rate that influences the business valuation – the cost of capital. The tax reduction increases the net cost of debt, being a component of the cost of capital, so ... perhaps it is better to keep this particular Pandora’s box closed...

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