What A Difference A Year Can Make – Interest Rates
When I meet with business owners during a valuation engagement I am usually asked “What can we do to increase the value of our company?” I make recommendations based on facts and circumstances of their business, but I also tell them that there are factors that are out of their control that can also impact value. Changes in interest rates and other economic factors such as inflation (increasing costs for materials and labor) will impact the value of their business.
Kroll is a leading Risk and Financial Advisory Solutions firm and in December 2022 published an article entitled 10 Trends To Watch Heading Into 2023. Included in their 10 Trends To Watch is “Developed Markets in Recession” and “Volatile Financial Markets and Market Dislocations.” Kroll points out that consumer confidence has fallen significantly in 2022 and that inflation has surpassed wage growth. To combat this the Federal Reserve increased interest rates which Kroll believes will eventually lead to a recession. Kroll points out that the volatility in the financial markets resulted in many companies seeing their market value decline significantly. The S&P 500 index was down 17% through mid-November 2022 and the Nasdaq posted a 30% loss through the same period. I don’t have to look any further than my 401(k) account to see the impact of volatile financial markets. Kroll believes many companies will see a decrease in their value due to an increase in their cost of capital. Kroll commented that many companies have increased their prices in order to pass along some of the increases in in raw materials, labor, and transportation costs but are feeling operation margin compressions as demand suffers from the price increases. Kroll believes this will continue into much of 2023.
I concur with Kroll and have seen margins tighten in 2022 and I also expect this to continue into 2023. I think business owners have a grasp of the margin pressure, but I am not certain that the impact of an increase in interest rates has hit home. One of the building blocks in determining the cost of equity capital is the 20-year Treasury security rate. On December 31, 2021, the 20-year rate was 1.94% and increased to 4.14% as of December 31, 2022, more than double the rate one year earlier. The cost of debt capital represents the expected average borrowing rate of the company and also contributes to the overall Weighted Average Cost of Capital (WACC). The WACC takes into consideration the proportion of the capital structure financed with debt at its cost and the proportion financed with equity at its cost. The cost of debt can be determined based on a number of factors including Moody’s Seasoned Baa Corporate Bond rate; current term debt borrowing rates derived from selected Treasury rates and a range of basis point mark-ups. Using these guidelines a reasonable debt rate on December 31, 2021 might have been 4.25% and the rate at December 31, 2022 using the same guidelines would be 6.75%. The increases in the 20-year Treasury rate and borrowing rate result in a higher WACC. A higher WACC results in a lower value when applied to the same level of cash flow. The point that I am highlighting is that even if the cash flow available to an owner of a business remains the same as in previous years the value of a business will likely be lower as interest rates increase.
Impact Rising Interest Rates
To explore the potential impact of rising interest rates I calculated an estimated WACC on December 31, 2021, and December 31, 2022, using identical inputs (costs of equity capital inputs, 20% debt / 80% equity financing assumptions, and the same tax rate) with the only difference being the change in the interest rates mentioned above. The WACC was 16.32% on December 31, 2021, and 18.44% on December 31, 2022. Assuming a long-term growth rate of 2.5% and $1 million of free cash flow the calculated enterprise value (the value of both debt and equity) of the business was over 13% higher on December 31, 2021, versus December 31, 2022. The only change in the inputs was the increase in interest rates. Facts and circumstances other than interest rates can change over time, but there is no denying that increasing interest rates can significantly impact the value of a business.
Visit our webpage for more information on McKonly & Asbury’s Business Valuation Services. Should you have questions about the impact of increasing interest rates, or business valuations in general don’t hesitate to contact me, T. Eric Blocher CPA, ASA, CVA.