# Capital: Optimising valuation

Regular readers will know by now that some basic maths is unavoidable in finance. Please be assured that it’s my objective to keep this to a minimum and to make the subject more accessible. A lot of what finance does is around the quantification and pricing of risk and returns – as such there are far more hard-core maths and stats in finance than is suitable for the average reader (but fun for those of us who like numbers). If you get stuck on a concept please read back through prior articles in this series or email me and I’ ll try to help: finweek@valuationup.com.

This column attempts to bring an understanding of the techniques big companies use to maximise their share price (ie their valuation) to the world of entrepreneurs and SMEs. The understanding most entrepreneurs lack is around how they can use corporate finance principles to maximise the growth and valuation of their businesses, and within this its capital structure where entrepreneurs tend to be even weaker; unlike big companies where capital structure is a key variable that’s managed regularly, few entrepreneurs understand it and very few manage it. A lot of value is left on the table and today I’ll try to show you how to figure it out. We’ll be bringing together the DCF valuation using different WACC (weighted average cost of capital) options as the discount rate. The objective is to see what Capital structure optimises the value of the firm. Previously, 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)

Where CF1 = Cash Flow in year 1, CF2 = Cash f low in year 2 etc, r is the discount rate (ie the WACC), and g is the growth rate in % that we predict in the long term. If we have expected cash f lows of R7m, R8.5m, and R10m in each of years one, two and three, a growth rate of 3% and a WACC of 20% then the model works out like this:

DCF = (7/1+20%)+(8.5/(1+20%)^2)+(10/ (1+20%)^3)+(60.58/(1+20%)^4) DCF = 46.7m Now, let’s recap how we build up the formula for the weighted average cost of capital: 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 Let’s work through some scenarios. Assuming a firm needs R10m of capital and the corporate tax rate is 30%.

One can see from the table below that the value of the firm in this example is maximised with a capital structure that has 70% equity and 30% debt. Increasing the debt beyond this increases the cost of capital as lenders charge more to cover the risk of default, which goes up as the same cash f lows are used to fund (and assets are used to secure) increasing levels of debt.

The quick hack for entrepreneurs without a calculator is to have around 25%-35% of your firm funded by debt.

Since banks will always require some form of security around the money they lend to you, which may include the cession of debtors, assets and personal sureties, you will have to see a complete proposal from a bank before you consider the optimal level based on your own circumstances. It pays off each time to keep your banker honest by getting proposals from competing banks for your business. A difference of 1% can make several million rands’ difference to your valuation and is worth fighting for. For example, a friend of this column, who runs an inbound safari-touring business with 20 buses, managed to get his bank to offer him 1% less on his vehicle finance by telling it that he was speaking to ones of its competors. This allowed him to buy an additional bus in just a few years.

We’ll do a quick recap next week, before moving on to look at how to assess the performance of your business and increase its potential over the coming months.