Effects of a sales tax increase on firm valuation in Japan: A free cash flow approach

This paper investigates how firm values change by increased sales tax rate, and further extends the analysis by applying plausible alternative input values of tax rates including the corporate tax rate applied to Japan, where both sales tax rate hike and corporate tax rate reduction are simultaneously proposed by the government. Our computation is based on the residual income valuation model by Edwards-Bell-Ohlson starting from the discounted free cash flow (DCF) model, both applied at the individual firm level, assuming March 31, 2012 as an evaluation date. We interpolate the future cash flow stream of firms from pro forma financial statements using Arzac’s (2008) computation method. His model structure is suitable to predict the sales and cost parameters at each firm level. Based on the system of equations for pro forma financial statements, we first compute free cash flows (FCF) in future periods up to 10 years. After 10 years we use the dividend discount model. Then, we analyze the effects of these tax rates and demonstrate the distributions of firm value changes for each tax parameter value. We find that an increase in sales tax rates decreases equity values for a majority of firms, but not necessarily all firms, and the sum of sales and corporate tax revenues increases for the central government. A corporate tax rate cut helps increase the equity value for a majority of firms. The trade-off relationship of a sales tax rate hike and a corporate tax rate reduction is subtle, but the suitable mix helps increase equity value of firms overall. For example, when the corporate tax is reduced 5% to 30.16% and the sales tax rate is increased to 10%, the median firm will not suffer. Policy implications from the current study are important for both tax regulators and corporate financial managers.