Principles of Private Firm Valuation

opportunities and S is capital-constrained, it follows that the value of S will be
lower relative to the value of an equivalent C. Therefore, if a firm is facing sig-
nificant investment opportunities, particularly if these opportunities are
strategic in nature, the firm should not make an S election. Rather, it would be
better served if it became a limited liability company (LLC) so it can preserve
its tax pass-through status and yet still have access to multiple outside capital
sources. In addition to capital constraints, private S corporations are also
likely to be less liquid than equivalent C corporations, as noted in Chapter 6.

138 PRINCIPLES OF PRIVATE FIRM VALUATION

TABLE 8.2 Values of C and S under Different Investment Paths

CS

Entity tax
Rate 0.40 0.40
Revenue $1,000.00 $1,000.00
Personal
Income tax
Rate 0.40 0.30
Costs $500.00 $500.00
After-tax cost
of capital
@40% 0.20
Pretax profit $500.00 $500.00
Tax on
dividends 0.15
Entity-level tax at 40% $200.00 $0.00
After-tax cost
of capital
@30% 0.23
Shareholder tax paid
by firm $0.00 $200.00
Growth (C) 0.05
After-tax income $300.00 $300.00
Low growth (S) 0.01
Capital expenditures $200.00 $50.00
Distribution to
shareholders $100.00 $250.00
Tax due on distribution $15.00 $0.00
After-tax income to
shareholders $85.00 $250.00
Value of C $1,833.33
Value of tax saving $75.00
Initial value of S $1,537.28
Value of S −value of C −$296.05
Final value of S $1,612.28