The Implications of Tax Reforms on Firm Valuation and Management Decisions

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The Implications of Tax Reforms on Firm Valuation and Management Decisions*

Due to accounting conventions and accrual concepts, actual cash receipts and actual cash outlays resulting from investment in real assets vary from the reported accounting numbers. Firms may accelerate or delay recognition of investment expenditures as represented by depreciation schedules and are permitted discretion in the assignment of inventory expense according to standard accounting practices. Public Policy that ultimately aims to encourage real investment must balance the needs for disclosure and public welfare with investment incentives. As a result, public policy makers should desire to encourage investment, while at the same time they should lead capital markets to anticipate the benefits of such activities. Management, on the other hand, needs to synchronize investment and policy decisions with the financial market. Thus, management must anticipate how the financial markets will view its actions following tax law changes.

The tax reform acts in the early 1980's had a number of countervailing influences with regard to new investment. Meyer [16] documents an increase in capital expenditures following the implementation of the tax acts. Dopuch and Pincus [19] examine the results with regard to inventory valuation and produce inconclusive findings. However, a major unanswered question is how the financial markets reacted to the new investment. Thus, the need exists for a comprehensive model to determine the impact of accounting tax law changes on the value of the firm. The purpose of this research is to develop a model and methodology to measure market reaction to firm behavior following tax law changes and to determine whether the impact is favorable or unfavorable on firm valuation. This model will allow the management of a firm to anticipate the impact of government policy decisions that after the fundamentals of firm valuation.

Economic conditions of high inflation and low business investment rates that existed in 1980 led to several policy decisions aimed at stimulating economic activity. A large portion of these policies were implemented through the Economic Recovery Tax Act of 1981 (ERTA) and its successor, the Tax Equity and Fiscal Responsibility Act (TEFRA). ERTA and TEFRA affected real investment by altering accounting conventions regarding depreciation, investment tax credits, and inventory valuation. By focusing on the impact on the market of these tax reform acts, we also hope to be able to anticipate the impact of more recent reforms for which insufficient empirical evidence exists.

RELATIONSHIP BETWEEN ACCOUNTING

CONVENTIONS AND FIRM VALUE

The theories of corporate accounting and finance relate the impact of information to the market value of ownership claims of the enterprise. Information pertaining to the value of an enterprise represents signals that describe the distribution of possible returns resulting from future cash flows to investors. This information affects firm value and aggregate wealth in the economy to the extent that firms' management alter their decisions and investors alter their expectations of future behavior. As a foundation, this study follows the basic research that establishes that accounting information facilitates the process of valuing an enterprise (Beaver, Kettler, and Scholes [2], Gonedes [11], Griffin [12], Eskew and Wright [10]). Thus, we use the financial data in accounting statements to develop our model of market response to changes in tax policy.

A major objective of public policy is to influence the behavior of corporate management to invest in real assets since these increase aggregate net worth. Firms will do so if they anticipate a favorable market reaction either due to increased profitability or a redistribution of profits resulting from a change in tax structure. Public policy may affect the enterprise in two ways: (1) the book value of the enterprise as changes are reflected in the financial statements and (2) the market price of the enterprise as investors revise their estimates of future returns based on the new information. …