Cap­i­tal: Op­ti­mis­ing val­u­a­tion

Finweek English Edition - - BUSINESS - FI­NANCE FOR EN­TREPRENEURS By Gareth Ochse

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.

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