A major concern for entrepreneurs is when would be the best time to sell or buy a business. Several economists announce that over the next few years, we could enter a period of inflation. However, as we know, the preferred way to control a rise in inflation is to raise interest rates. In such a context, it is useful to ask what the impact of an increase in rates could be on the value of a company from M&A advisory.
Interest rates alone do not explain variations in value. In the following explanation, the rate variation is isolated and the rest of the factors that influence the value of a company remain unchanged. Although this assumption is unrealistic, our goal is to illustrate the mechanics of interest rates on the value of a company. To do this, we use a method based on the weighted average cost of capital. This method allows us to directly see the effects.
Let’s make some assumptions:
Let’s say the current Bank of Canada risk-free rate is 2%
The average interest rate for borrowings (considering the nature of the fixed assets) is 8%. It is possible to finance 50% of the transaction with debt.
The rate of return required by the acquirer for the capital investment is 25% after tax and therefore 28% before tax for this company. 50% of the value of the transaction would be required as a down payment.
The company has been generating $300,000 in EBITDA per year for at least 5 years.
The weighted average cost of capital for this transaction is therefore (8% interest X 0.50) + (28% capital X 0.50) = 18%.
To realize a 25% return on their investment, the acquirer would pay ($300,000/18%) = $1.67 million- or 5.5-times EBITDA.
4 years later
The Bank of Canada’s risk-free rate has risen to 5%.
Average interest rates are now at 12%. The required rate of return for the investor has increased from 28% to 32% before tax.
The company still generates an EBITDA of $300,000. All else being equal, the value of the business would be ($300,000/ ((12% x 0.50) + (32% *0.50)) = $1.36M or 4.5 times EBITDA with the help of an M&A advisor.
It would be surprising if over the next 4 years we were to experience such sharp upward swings in interest rates, but we can see that they have an impact on the value of a company.
In our example, we have assumed that all other factors remain equal. Unfortunately, the variation in interest rates influences other factors that also influence the value of a company.
For example, when interest rates increase. People save more, and the availability of cash decreases. Which has the effect of reducing the number of potential buyers in the market and. By training, multiplying the positive or negative effect solely from the rate variation.
In the following explanation. The rate variation is isolated and the rest of the factors that influence the value of a company remain unchanged. Although this assumption is unrealistic, our goal is to illustrate the mechanics of interest rates on the value of a company. To do this, we use a method based on the weighted average cost of capital. This method allows us to directly see the effects.