How rise and in­ter­est cov­er­age works

Finweek English Edition - - BUSINESS -

You own your busi­ness to make eco­nomic re­turns; for this task the f irm can em­ploy cap­i­tal raised from share­hold­ers (eq­uity) or it can em­ploy cap­i­tal that it raises from the bank (debt). Last week we in­tro­duced the con­cept of weighted av­er­age cost of cap­i­tal ( WACC) – the prin­ci­ple 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 f irm. 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 things af­fect 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’s 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 more 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 small busi­ness (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 per­cent­age points of the prime rate (de­pend­ing on the cash-flow health of the busi­ness, the eco­nomic con­di­tions and the level of se­cu­rity pro­vided – let’s say 15% to keep it sim­ple for now). Big com­pa­nies with healthy cash f lows 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. To il­lus­trate this bet­ter, I have sup­plied an ex­am­ple, avail­able here »

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