What’s the Cost of Capital?
Capital structure matters because it influences the cost of capital. Generally, when valuators use income-based valuation methods — such as discounted cash flow — they convert projected cash flows or other economic benefits to present value by applying a present value discount rate.
That rate, also known as the cost of capital, generally reflects the return that a hypothetical investor would require. When valuing invested capital — that is, the sum of debt and equity in an enterprise — the weighted average cost of capital (WACC) is used as the cost of capital. WACC is a company’s average cost of equity and debt, weighted according to the relative proportion of each in the company’s capital structure.
What’s the Optimal Capital Structure?
Many business owners strive to be debt-free, but a reasonable amount of debt can provide some financial benefits. Debt is often cheaper than equity, and interest payments are tax-deductible. So, as the level of debt increases, returns to equity owners also increase — enhancing the company’s value.
If risk weren’t a factor, then the more debt a business has, the greater its value would be. But at a certain level of debt, the risks associated with higher leverage begin to outweigh the financial advantages.
When debt reaches this point, investors may demand higher returns as compensation for taking on greater risk, which has a negative impact on business value. So, the optimal capital structure comprises a sufficient level of debt to maximize investor returns without incurring excessive risk.
Identifying the optimal structure is a combination of art and science. Valuators may:
- Use industry averages,
- Examine capital structures of guideline companies,
- Refer to financial institutions’ debt-to-equity lending criteria, or
- Apply financial models to estimate a subject company’s optimal structure.
Whichever method is used, valuators exercise professional judgment to arrive at a capital structure that makes sense for the subject company, with a level of debt that the company’s cash flow can support.
Which Structure Should Be Used?
The right capital structure for valuation purposes depends on several factors, including:
Type of interest. If the interest being valued is a controlling interest, it’s often appropriate to use the company’s optimal capital structure. Why? Because a controlling owner generally has the ability to change the company’s capital structure and gravitates toward a structure that will yield the most profitable results. If the interest being valued is a minority or noncontrolling interest, however, it’s customary to use the company’s actual capital structure, because the interest owner lacks that ability.
Purpose of valuation. To estimate fair market value, valuators often use the subject company’s actual or optimal capital structure. But if the standard of value is investment value, it may be appropriate to use the buyer’s capital structure because the buyer’s financial attributes are considered in using this standard of value.
Management plans. A company’s capital structure fluctuates over time as the value of its equity securities changes and the company services its debts. It may be appropriate to use management’s target capital structure if the actual structure has veered off course temporarily or if management plans to alter the company’s capital structure.
Finding the Right Structure
The blend of debt and equity can have a big impact on a value estimate. So you should expect to work closely with your valuation expert to identify the appropriate capital structure to be used in the valuation.