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1. The discount rate appropriate for the NOL benefits will generally be different
from the weighted average cost of capital (WACC) used for the business. Because
the NOLs can only be utilized if the business generates positive EBT (after inter-
est expense), an equity cost of capital is often considered to be appropriate. fn 18

2. The utilization of NOLs will not typically match the pattern of income tax ex-
pense in the projections prepared for the income approach. The projected cash
flows used in an enterprise valuation typically do not include interest expense,
which will affect the timing of the utilization of an NOL. An example of the inter-
action between interest expense and NOLs is presented in appendix 1. NOL utili-
zation can also be affected by many complex tax attributes of the company and
may need to be forecast separately with the assistance of tax professionals.

3. The utilization period for NOLs may extend beyond the explicit forecast period of
the projections prepared for the income approach; accordingly, it is common to
separately value the NOL.

When calculated separately, the net present value (NPV) of the NOL benefits is added to
the value derived from the income approach prepared for the subject business. It may also
be appropriate to add the NPV of the NOL benefit to the value derived from the market
approach.

 Tax-Affecting Cash Flows for Pass-Through Entities. Tax-affecting pass-through entity cash
flows are generally supported by finance theory and widely adopted by business appraisers. Tax
affecting is controversial, however. Accordingly, the appraiser should carefully consider the sub-
ject, jurisdiction, and relevant court cases prior to its application.

The principal arguments in favor of tax-affecting pass-through entities (which include S corpora-
tions, LLPs, LLCs, and similar types of legal entities) include the following:

1. Taxes on pretax profits of pass-through entities must be paid by the owners, and these
taxes will be factored into the value of the ownership interest by investors.

2. If a potential buyer of a pass-through entity is a C corporation, the buyer will tax affect
the cash flows in valuing the enterprise. This argument becomes stronger when the size
of the pass-through entity is large enough to make it a target of publicly traded acquirers.

3. A buyer of a controlling interest in a company would not pay a premium for pass-through
status if the owner could elect pass-through status at a nominal cost.

That said, tax-affecting pass-through entity earnings are a controversial topic. There are tax ben-
efits to the owners of pass-through entities, which can affect value depending on the facts and
circumstances. The principal benefit is the avoidance of double taxation on dividends paid. This
benefit can be relevant when valuing minority interests in pass-through entities that pay divi-
dends. Recently, there have been a number of court decisions that do not support tax affecting of

fn 18 A discussion of the appropriate discount rate to present value NOLs is contained in the “Income Approach” section of this chap-
ter.

© 2020 Association of International Certified Professional Accountants 55