How rise and interest coverage works
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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