Interest coverage and the cost of debt

You own your business to make economic returns; to this task the firm can employ capital raised from shareholders (equity) or they can employ capital that they raise from the bank (debt). Last week we introduced the concept of Weighted Average Cost of Capital (WACC) – the principal of which is that equity and debt carry different levels of risk and thus demand different returns and that by optimising the mix of capital we can reduce the overall cost of capital to the firm. Since we use the WACC to discount future earnings in our DCF, it follows that the optimal (lowest) WACC will result in the optimal (highest) DCF valuation and that managing WACC is a key task in growing the value of the firm.

In this article we’ll look at what affects the returns required by debt and equity capital.

Debt and equity carry different levels of risk and thus demand different levels of return. The important thing about equity is that it gets paid last and is all at risk until this time.

So what then is the required return on the equity side of the business? For big companies, equity investors demand a return that is higher than (a) the risk free rate they can get by investing in US treasury bonds (in theory very safe, unlike Greek treasury bonds) – say 2%, plus (b) a premium on the above to account for the risk in the country where the firm is based – say another 6%, plus (c) additional risk for how much the market returns vary from the country’s fundamentals (say 4%), plus (d) additional risk for how much the sector returns deviate from the market– say another 5%, plus (e) additional risk due to it being a small business with low trading volumes (another 4-5%) etc…this can add up to higher than 20% – and that’s for a big established company with a defined market, strong management team, lots of track record, formal audits, analyst coverage, expensive systems to generate and secure revenues and a healthy balance sheet.

At SMB level things are far riskier. SMBs die far more often than big companies, have weaker balance sheets, far lower levels of oversight, and much higher risk…so as the equity holder you are probably looking for at least a 30% return on your capital. Early stage investors need to be looking for 40%+ returns.

So what does debt cost? Debt gets paid first, even before taxes, and in most cases is secured by a lien over the assets of the business or of its owners. While certainly not risk free, debt is relatively secure when compared to equity and it’s priced accordingly. A typical rate on a business term loan will be within a few % points of the prime rate (depending on the cash-flow health of the business, the economic conditions and the level of security provided – lets say 15% to keep it simple for now). Big companies with healthy cash flows and strong balance sheets will be paying a rate close to or even below prime. The biggest carry so little risk that they can issue their own long-term bonds and pay substantially less than prime on their debt.

So with SMB equity costing 30% and debt 15% (again, this is for illustration only), it would make sense to structure the firm with as much debt and as a little equity capital as possible? Surely this would optimise ROE? The answer is “up to a point” – a bank will lend you money where the business is highly profitable and can easily afford both the interest and capital repayments on the debt but at a point it becomes harder for the business to make the monthly repayments and the bank compensates for this risk by increasing the interest rate it charges, which reduces the interest coverage again.

An example may help:

Lets say you make monthly profits (EBIT) of R1M and you pay R100K interest to the bank each month. Your interest coverage ratio is 10x (=EBIT/Interest expense). Your bank manager sleeps peacefully at night and you rarely interact with him. Then you buy some more machinery and another business. Growth is good and you are now paying R250k interest per month. Interest coverage has dropped to 4 and the bank has increased the interest rate it charges you to account for the higher lending rates (and the higher risk that you will default). Still, all is rosy. Then just as you’ve received additional loans for working capital, your major customer goes under. You lose R400K of monthly revenues and have added R50K of debt, so your interest coverage is now =600/300 =2. Suddenly your bank manager isn’t sleeping too well and you have daily meetings with him to figure out how to improve the situation. The cost of your debt increases because you are now under the required interest coverage ratio stipulated by your bank when you took out your first loan, and suddenly you are paying an additional R50K a month of interest. So you’re now at R600K of EBIT and R350K of Interest giving you an interest coverage ratio of 1.7 – you desperately want to borrow more but your bank refuses. The cost of your debt has risen from 15% to nearly 25% and It’s crippling you.

Your only hope for expansion capital is to attract more equity investment, however the potential equity investors look at your business realise that it will be a long time before they see a cent of their money – servicing the bank debt will take a long time. You’re stuck with having to trade your way out, or sell off assets to pay back debt…you wish you’d only been more conservative and not taken on so much debt in the first place.

We’ll discuss what you optimal capital structure should look like in next week’s article.

Please feel free to share you war-stories/comments/feedback with @valuationup

Introducing Capital Structure

One of the purposes of these articles is to bring an understanding of the value-creating tools that big companies use to the entrepreneur. Optimising the value of the firm by optimising its cost of capital is one such tool – one which big companies use extensively yet most entrepreneurs don’t. Today, I’ll unpack how we use Cost of Capital in Valuation and show how some simple tricks can help you increase the value of what you’re building.

The key principles are:

  1. We value a firm based on the future cash flows that it generates, discounted back to present (the DCF valuation we’ve covered in earlier articles).
  2. To achieve these future returns, we employ capital.
  3. This capital can be in the form of debt or equity. (In the entrepreneurial world, we deal mainly with common stock/shares and term-loans, so we’ll keep the scope to those two forms).
  4. The interest we pay on the capital we employ is its cost of capital.
  5. The total cost of capital for the business depends on the proportions of debt and equity used and the cost (interest rate) of each. This is called the Weighted Average Cost of Capital (known simply as ‘WACC’).
  6. Since the WACC reflects the cost of financing the business, we use WACC as the discount rate for our DCF valuation.
  7. Therefore, optimising the WACC also optimises the value of the firm.
  8. Firms at different stages in their lifetimes have different needs, risk profiles, growth rates, and cash generative abilities. Therefore the mix of capital for a start-up is very different to the mix of capital for a mature stage firm.
  9. This means that as a firm grows, its WACC needs to be managed to ensure the most appropriate mix of capital for the firm at the stage it is in; not doing this reduces the value of the firm.
  10. Lastly, while debt can increase the returns to the equity holders, too much debt will increase risk in the business and reduce valuation.

Summarising the above: WACC is something you need to understand and manage.

Let’s show how it’s calculated:

WACC = (E/(E+D))*Ke+(D/(E+D)*Kd)*(1-t)

E=$ value of equity

D=$ value of debt financing

Ke=Desired return (%) on equity

Kd=Interest rate on debt

t= corporate tax rate.

This is not a complex as it looks. All we’re trying to do is multiply the proportion of debt capital by its cost and ad this to the proportion of equity capital times its cost. The trick is to remember that since interest expenses are tax-deductible, the cost of debt is reduced by the corporate tax rates.

Here’s a worked example, where a firm has R3M equity financing and investors who want 30% on their money, and long-term debt of R7M at a cost of 15%. The tax rate is 30%.

WACC =(3/10)*30%+7/10*15%*(1-30%)

=9%+10.5%*(0.7)

=16.4%

If interest rates go up, say to 20%, then the WACC will change to 19%.

So how does this affect us in our valuation calculations (and our efforts to increase the value of the firm)?

We use the WACC of the company to discount its future cash flows. So if the WACC goes up, the value of the firm goes down.

One big word of caution: Although increasing the level of debt in a business will generally bring down its WACC (because debt is generally much cheaper than equity), remember that debt requires regular monthly payments to service it. So if your business is very profitable and can service more debt then it makes sense to increase the level of debt. If you think hard times are coming, then remember that the cost of debt will rise and you’ll need more profits to service the same level of debt. Debt is a great lever that can increase the returns to equity holders, but like any lever if its over-stressed it can snap with painful consequences.

In next week’s article we’ll revisit our DCF valuation, using various WACC calculations to show how, as an entrepreneur, you need to think about your WACC as much as you do about your strategy or operational effectiveness.

 

Please feel free to share you war-stories/comments/feedback with @valuationup

Which discount rate to use in Valuation?

Your business is worth the present value of the future cash flows that we expect it to generate. Since we are dealing with forecasts, there is a very high risk that the actual cash flows the business will generate will be different to what we’ve forecast. The discount rate we use attempts to bring those future cash flows to a reliable value in today’s terms by accounting for the likely variability (“Risk”) in their actual returns.

Last week we built up a DCF valuation using the following formula and cash flows:

DCF=(CF1/(1+r)^1)+(CF2/(1+r)^2)+(CF3/(1+r)^3)+{(CF3*(1+g))/(r-g)}/(1+r)^4)

If we have expected cash flows of R700, R850, and R1000 in each of year 1,2 and 3, a growth rate of 3% and a discount rate of 20% then the model works out like this:

DCF=(700/1+20%)+(850/(1+20%)^2)+(1000/(1+20%)^3)+(6058/(1+20%)^4)

DCF=4673.69

As explained in a previous article, the DCF is highly sensitive to its inputs (which is why its so useful – it’s mathematically robust but its use also forces you to understand the business is more detail). So let’s see what happens with different discount rates:

Discount rate 15% 20% 30% 40%
DCF valuation 6816 4674 2832 2032

Those are big differences. So how do we choose which discount rate to use? Broadly, there are 3 different discount rates that we see in use:

  1. ‘Desired ROI’: Some people build their idea of risk into the returns they want on their money. So you’ll see someone say that they want to make a return of 20% from an investment in business A, or a return of 30% from business B. What they are saying is that they view business B as more risky than A. Quite simply, if someone was happy with a 20% return and the asking price was less than R6674, you’d expect them to buy. Since this desired ROI is very personal and not particularly scientific, we don’t encourage its use (we do use it on ValuationUP.com, but its weighting is very light).
  2. ‘Educated-gut-feel discount rate’: A simple hack is to look at the future competitiveness of the firm/industry and give it a discount rate that ranges between 15% (low risk) to 50% (very high risk). The basic theory here is that if an industry is highly competitive, if the business depends on a few suppliers for input and a few customers for demand, if there is major capital investment required in the next few years, and if the business is highly vulnerable to energy prices, then the discount rate will be closer to 50% then 15%. We see people sort-of go through this process when looking at business, but they don’t bring it back into the DCF in a robust manner. On ValuationUP.com we do use this method but in a far more robust way– building our own view of a discount rate based on the results of a survey that covers most of the likely risks to a firms future; it gets a medium-weighting in our overall valuation calc.)
  3. Weighted Average Cost of Capital (WACC): The key principle here is that the discount rate we use depends on the financing structure we use in the business. This is important because the immediate implication is that the valuation of the business depends on the way we finance its growth. With that simple statement we open the door to explaining how the choice of debt and equity (“capital structure”) used to finance a firm fundamentally influences its value. As such, it’s a key factor that requires insight and management if the value of the firm is to be maximised. WACC is in our opinion, really the only way to build up the discount rate, so we’re going to introduce it here and pay full attention to it in our next articles.

A brief primer on capital structure:

Capital structure is the name given to the mix of debt (money you borrow from lenders such as banks) and equity (capital invested directly into the business by investors in exchange for shares in the business).

Finance isn’t only restricted to pure debt and equity – there are all sorts of other instruments one can use to finance a firm. On the equity side, big companies use a mixture of common and preference shares. On the debt side, big companies can borrow money from bank, can borrow more expensive ‘mezzanine’ debt, and can even go as far as to issue their own long-term bonds. You also get loans that can convert from debt into equity, and preference shares that can convert into common stock…and of course there is a whole market for credit risk we know loosely as ‘derivatives’.

In the world of entrepreneurial finance, things are simpler: we’ll be concentrating on long-term debt borrowed from a commercial bank, and on common equity bought by investors.

In next week’s article we are going to unpack the Weighted Average Cost of Capital – and to use this to get to a far more reliable/robust view of the appropriate discount rate to use in our valuations. For those wanting to optimise the value of the firm, this is great stuff and an eye-opener.

Please feel free to share you war-stories/comments/feedback with @valuationup

Calculating the Discounted Cash Flow Valuation

Calculating a Discounted Cash Flow (DCF) Valuation relies on assumptions about cash flows the firm expects to generate, the growth rate of the firm, the inflation rate of the country, and the amount of risk we expect (or alternatively, the amount of extra return we want on our cash investment to compensate for the risk we expect). All of these variables need to be forecast a long way into the future.

Before anyone suggests that with so many assumptions about the firm’s future that the valuation might be inaccurate or that the DCF valuation method might be inferior to others for SMBs, let me reinforce the message that ‘two businesses in the same industry with exactly the same financial statements at the same time can face very different futures, and thus have different valuations’. This simple statement shows that whereas Net Asset Value or a Multiple/comparable approach would both value the businesses equally, only the DCF forces us to consider the future cash flows and the level of risk/uncertainty around them, and only the DCF method would help us choose between the two otherwise equal businesses.

Let’s get stuck in: I’m going to keep things as simple and as broad today as possible, with further depth and refinement in future articles.

Forecasting something into the far future is tricky. For SMBs the trick is to break our forecasts down into 2 periods: an initial period where we forecast growth and cash flows year by year (and where we expect the business to grow faster than the economy), then a second period where it grows more or less at the same speed as the economy. Typically this first period is 3-5 years, and the second period is everything thereafter. To make things easy we employ a mathematical trick of treating the second period as a single lump sum that we then discount back to present along with the other years. This means that we only have to calculate 3-5 years of specific cash-flows with the rest being sorted out by some simple maths. Suddenly the DCF Valuation is not so daunting!

The formula for each of the first few years (the ‘high-growth’ period) would look like this:

PV=(CF1/(1+r))+ (CF2/(1+r)^2)+ (CF3/(1+r)^3)

Where CF1 = Cash Flow in year 1, CF2 = Cash flow in year 2 etc, and r is the discount rate.

What about the cash flows that come after 3 years, i.e. 4 years to infinity? Here we use a formula (derived from the Gordon growth model) that allows us to treat this as a single cash flow in year 4.

FV=CF*(1+g)/(r-g)

CF with the subscript t+1 means that we are using next years cash flow forecast, not the prior years actual cash. g is the growth rate in % that we predict in the long term.

So if we have projected cashflow in year 3 of R1000, a growth rate of 3%, and a discount rate of 20% then we’d use FV=(1000*(1+3%))/(20%-3%)=103/0.17=R6058, which would reflect cumulative effect of all cash flows from year 4 onwards.

The important points here is that (1) we add the growth rate of 3% to the cashflows expected in year 3 to get to what we expect in year 4, then (2) we divide this by the discount rate less the growth rate to get to the ‘in perpetuity’ calculation. Lastly, since this lump sum now sits 4 years out, we must discount it along with the cash flows we expect in years 1 to 3.

So putting these together we end up with something that looks like this:

PV=(CF1/(1+r)^1)+ (CF2/(1+r)^2)+ (CF3/(1+r)^3)+ {CF3*(1+g))/(r-g)}/(1+r)^4)

If we have expected cash flows of R700, R850, and R1000 in each of year 1,2 and 3 then the model works out like this:

PV=(700/1+20%)+(850/(1+20%)^2)+(1000/(1+20%)^3)+(6058/(1+20%)^4)

PV=583.3+590.2+578.7+2921.5

PV=4673.69

There you have it – a DCF valuation at last!

 

In the coming weeks we are going to unpack and repack this further, with the main focus on being how to use the DCF valuation as both a means of setting price in negotiations, and as the single number that shows you how the decisions you are making in your business today affect its long-term value.

 

Please feel free to share you war-stories/comments/feedback with @valuationup

ValuationUP.com wins ‘best African tech startup’

We entered the Tech4Africa Ignite! start-up competition, which ran during Tech4Africa last week. From the online entries, only 12 start-ups were selected to attend the event and mentoring sessions. After a day of mentoring and practice pitches, 5 finalists were chosen to present to the entire Tech4Africa audience the following day. Thankfully that included ourselves.

The final pitches went well with us going last (alphabetical order helped). Feedback from the audience was good but the judges only announced the winner late in the afternoon sessions, so it was a bit nerve-wracking. Finally the announcement was made – we had won with a unanimous vote from the judges, all of whom are experienced VCs.

The prize was R25K (about $3K) sponsored by Deloitte – while not much, its appreciated. We’ll spend a bit on a dinner with our respective wives (to thank them for their patience) then the rest will go into marketing (and global domination).

What does this mean for us? Well its a nice bit of exposure, some cash, and its great validation of the strength of the business we are trying to build. We’re in the process of raising funding and this has helped us open doors where we would have otherwise struggled for longer. Mostly, its a morale boost at a much needed time.

Thanks to YOU for your support.

– Gareth & Kenneth