December 19, 2012 | Issue #123-3  

Holiday reading: Two new cost of capital papers tackle taxes, beta

Aggressive tax avoidance policies can increase corporate cash flows (and shareholder value) but invite greater uncertainty and possible future costs to the firm. Current accounting authorities have attempted to use such strategies as proxies to capture a firm’s overall tax risk. A new research paper, “Tax Risk and the Cost of Equity Capital,” evaluates the extent to which these recently developed proxies accurately measure the firms' risk, as reflected in the cost of capital. After conducting their study, authors Michelle Hutchens and Sonja Rego (both from Indiana University) find:

The level of a firm’s reserve for income taxes is significantly positively associated with the cost of equity capital, consistent with tax reserves capturing uncertainty surrounding a firm’s tax positions, i.e., tax risk. However, we also find that several other proxies for aggressive tax avoidance are not associated with the cost of capital, while lower cash effective tax rates are associated with lower costs of capital. We conclude that these tax avoidance metrics do not capture uncertainty surrounding a firm’s future after-tax cash flows and, therefore, do not capture a firm’s exposure to tax risk.

A second paper takes a look at the “routine steps” of levering/unlevering beta in various cost of capital models that valuation analysts commonly use in the income approach. In “The Pitfalls of Levering and Unlevering Beta and Cost of Capital Estimates in DCF Valuations,” authors Robert Holthausen (University of Pennsylvania) and Mark Zmijewski (University of Chicago) examine current research and conclude:

The levering and unlevering formulas that are most commonly used in practice are not appropriate for valuing many companies. They also illustrate the shortcomings of—and substantial valuation errors that can result from—the common practices of assuming that the betas of securities like debt and preferred stock are equal to zero and ignoring the effects of equity-linked securities such as employee stock options, warrants, and convertible debt.

The article appears in the current issue of the Journal of Applied Corporate Finance(available by subscription only). Notably, the authors have published a second article in the same issue: “Valuation With Market Multiples: How to Avoid Pitfalls When Identifying and Using Comparable Companies.”

Key drivers of medical practice value: a new,
free resource

In a recent article on “hospital wars,” The New York Times has just recognized what healthcare appraisers have known for a while, that large hospitals across the country have been rapidly buying physician practices—from general practitioners to cardiologists to orthopedic surgeons—turning local communities into “battlegrounds” for the lucrative medical market.

Value is driving the trend. BVR’s latest special report, Physician Practices: Key Value Drivers in a Changing Environment, takes a look at both sides of the battle, including:

  • Top value drivers in physician practices;
  • Understanding physician compensation and compensation arrangements;
  • The questions to ask in a practice acquisition;
  • Potential practice acquisition deal breakers;
  • Successful integration of a physician practice; and
  • Financial benchmarks and acquisition multiples.

To sample the depth of new information available in the special report, we’ve just made the first chapter, by Carol Carden (Pershing Yoakley & Associates), available as a free download. To access your free copy of “The Top Five Value Drivers in Physician Practices,”—which highlights appraising ancillary services, physician extenders, payer services, and more—click here now .

AICPA’s Parker updates aspects of ABV credential

While reviewing NACVA’s just-published credential summary, Eddy Parker, senior technical manager for the AICPA’s Forensic and Valuation Services, notes it provides a “good comparison,” but he has these additional observations:

  • The chart lists two years of CPA experience as a prerequisite for the CVA credential, yet does not indicate that both the ABV and CFF credentials require a valid, unrevoked CPA license, which in many states (depending on licensing standards) depends on similar work experience;
  • The BV experience requirement for the ABV credential is currently six engagements or 150 hours of valuation work;
  • The CFF credential does not require five years of accounting experience;
  • Footnote 6 references the ABV proctored exam, and not (as currently referenced) the CPE requirements for the CFF;
  • Currently about 5,000 appraisers hold the CFF credential and 3,100 hold the ABV;
  • Total membership in the FVS section is now approximately 7,500;
  • AICPA membership varies between $220 and $395; the chart notes only the higher amount;
  • The chart does not mention the $250 recertification fee for the CVA credential; there is no fee to recertify for the ABV or CFF; and
  • Neither ABV nor CFF holders must purchase AICPA education to maintain their credential.

Parker indicates that he will be sending NACVA his comments.

No ‘foolproof blueprint’ for successful FLPs, Bogdanski says

In his annual year-end symposium on federal tax valuation case law, Prof. John Bogdanski (Lewis & Clark Law School) says recent cases concerning family limited partnerships (FLPs) should “encourage” taxpayers—as well as their appraisers and attorneys. At the same time, the Tax Court’s “unpredictable” interpretation of IRC §2036(a) means there is no "foolproof blueprint" for securing a win in these cases, which translates into the court adopting the funding and formation of the FLP as well as accepting its associated, discounted values. For example:

  • In Estate of Stone v. Comm’r, TC Memo. 2012-48, the court accepted the FLP’s nontax purpose as the management of the family’s timberland. The decision “surprised” many observers, Bogdanski said, because the partnership did not engage in a business or investment activity, had no liquid assets or bank account, and did not change the nature of the property.
  • Compare this to the court’s final decision in Estate of Turner v. Comm’r, 138 T.C. No. 14 (2012), when it declined to reverse an earlier ruling that included the entire fair market value of the FLP assets (passive investment securities) in the decedent’s gross estate. Among other reasons, the operative documents used “boilerplate” language in stating the partnership’s nontax purpose and discrediting testimony from the advisors that tax advantages were not an element of formation.

It's difficult to reconcile these two outcomes, Bogdanski concluded, which may depend on the court’s interpretation of the particular facts and circumstances under 2036(a) as well as the parties’ credibility and sympathies. As a final note, Bogdanski mentioned the IRS’s “nonacquiescence” to the Wandry decision on defined-value clauses. Considering the applicable forum for the appeal (the 10th Circuit), which apparently shares a “pro-taxpayer” stance with the 9th Circuit, Bogdanski says the IRS may want to pursue challenges against formula value clauses further east. Note: All cited opinions—in addition to all relevant case law on FLPs, from the Tax Court and the federal circuits—are available at BVLaw.

Damodaran on the ‘foolhardy versus rational’ value of goodwill

“There is no asset on a company’s balance sheet that wreaks more havoc on valuation and good sense than goodwill,” writes Prof. Aswath Damodaran (NYU Stern School of Business) in his latest blog post. “The first problem with goodwill is that it sounds good, and when something sounds good, people feel the urge to pay for it. The second problem is that, notwithstanding claims to the contrary, it is not an asset but a plug variable that measures everything and nothing at the same time.”

Full employment act for appraisers? Recent changes to the financial accounting standards related to valuing goodwill impairment have also created, “for better or worse, … a lucrative jobs program for accountants & appraisers, since their services are now required both at the time of the acquisition (to reappraise the value of the existing assets) and each period thereafter (to assess target company values),” the professor adds. “As is the case with most accounting rules, the rules have [also] obscured the principles of what the changes were meant to accomplish: create more transparency for investors about acquisition costs and more accountability for bad acquisitions.”

A modest proposal with ‘zero’ chance of acceptance. In prior posts, Damodaran has noted that in about 55% of acquisitions, the stock price of the acquiring company will drop. If this price decline equals the market’s collective judgment of an overpayment, then “why not break goodwill down into two components: The market ‘correction’ can be called foolhardy goodwill and the rest can be rational goodwill,” the professor suggests. Thus, if an acquirer pays $12 billion for a company with an adjusted book value of $4 billion and sees its market cap drop by $3 billion on the announcement, then the balance sheet should show $3 billion in foolhardy goodwill and $5 billion in rational goodwill. With hindsight, both types may require impairment, but Damodaran would argue “that firms—their top managers and bankers—should be held much more accountable for failures on the former, because they chose to do the acquisition in the face of investor opposition.”

Seasonal discount on CPE training

For a limited time, BVR is offering all 2012 Training Packs at special, seasonal rates. Whether you had to miss a webinar during the year or simply want to have that recording plus transcript, handouts, and slides, you can purchase a copy at 15% off the original price from now until the end of the year. Just use PRIOR1436 when ordering through our website, or contact our customer service by email or phone: (503) 291-7963. With our new digital distribution system, you can receive a complete Training Pack instantly when you download it from our website.

IFRS Foundation releases 2013 ‘Blue Book’ of standards

The IFRS Foundation has just published the 2013 International Financial Reporting Standards Consolidated without early application. This updated edition of the so-called “Blue Book” includes the latest consolidated versions of all standards (including IFRSs, IASs, and IFRIC and SIC interpretations) as approved by the International Accounting Standards Board up through the end of December 2012 and that are effective as of Jan. 1, 2013.

This volume is available to purchase as a PDF download or as a bundled product (PDF download plus printed version).

Everything you ever wanted to know about discounts is coming in January

On January 8, 2013, don’t miss the fourth of five parts of BVR’s 5th Annual Online Symposium on Estate & Gift Tax, Pass-Through Entity Discounts for Built-In Capital Gains Taxes, featuring Mel Abraham (Mel Abraham Inc.) and William Frazier (Stout Risius Ross). Their program will focus on the current status of accounting for built-in gains tax liability when appraising pass-through entities (such as S corporations and LLCs) that hold highly appreciated assets. Learn which jurisdictions have accepted a dollar-for-dollar discount, and why the IRS (and a substantial number of BV appraisers) continues to favor a present value accounting for the “BIG” discount.

And throughout January we will host the Advanced Series on Discounts for Lack of Marketability, a four-part series focusing on the challenges of determining, applying, and defending DLOMs, featuring curator John J. Stockdale (John Stockdale Business Valuation) as well as Michael Gregory, a former IRS engineer and now an independent consultant. For a full list of CPE programs, visit our training page.

Holiday schedule

After taking a break during the Christmas week, BVWire will publish its first 2013 issue on Thursday, January 3, after which it will resume weekly publication on Wednesdays beginning Jan. 9, 2013. Have a safe, joyful, and prosperous holiday season.


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