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.
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