Last week we discussed the threat of loss of talent to your business as a continuity issue. Interest rates are making a significant move higher. This is creating, and will likely continue to have, multiple impacts on businesses and their continuity strategies.
Joe Jay recently began working with Aspen Grove Investments and writes a newsletter for his business, Midwest Financial. He recently had a commentary on interest rates and wanted to challenge him on how this would impact business valuations and further implications.
Q: â€œWhat does all of this mean to the value of businesses we are or may be working with? What are the implications?â€
A: â€œGreat question.
Increases in risk-free (US govn’t bonds) rates, increase the cost of capital of all companies. The weighted average cost of capital is used to discount future cash flows.
Increasing this rate will increase the cost of debt and the cost of equity for companies. Both are inputs to the weighted average cost of capital calculation.
The increase in the cost of debt is straight forward. All rates will go up for borrowers.
The increase in cost of equity is due to the increase in market risk premium. Investors will not accept an amount of return less than the amount an investor can gain by investing in risk-free bonds (us govn’t issues).
So, by increasing the discount rate by increasing the cost of equity and debt, you lower the future cash flows because the discount rate is higher.â€
Joe is spot-on with his analysis. It is a bit technical but what it essentially means is that an increase in rates will have an exponential impact on the valuation of your business. As rates rise, buyers will have increasing alternatives for their investments and they will discount the value of a business based both on their cost of borrowing and on the perceived risk of owning an individual business.
There are some other potential impacts that you should consider as a business owner that may be less obvious but equally or more important:
1. What will be the impact on your suppliers?
- Do you know their financial structure and whether they are within their bank covenants?
- Do you know whether or not they are in danger of an increase in interest rates on or the curtailment of their lines of credit?
- Do they have debt service needs that will impact their ability to survive? Do they have balloon loans that will have to be refinanced at higher rates? How much of their rates are based on variable rate financing?
- Will they force cost increases on to you?
2. What will be the impact on customers?
- All of the questions above apply along with:
i. Have you increased your credit qualification for new customers and reviewed that of current customers?
ii. Have you seen an increase in Accounts Receivable days overall or from particular customers?
- Can you pass cost increases on to your customers?
3. Are you carefully monitoring inventory levels?
- Many businesses have gotten a bit careless on this issue since money has been cheap.
- Since you are paying interest, either explicitly or implicitly on your inventory it is critical that you look at ways to increase turns and reduce what you are carrying.
4. Are you factoring interest increases into long-term bids?
- This is one that often gets missed, particularly when rates are rapidly rising.
- Are you getting locked into bids without locking in your inputs and factoring increases in your carrying cost while you are waiting to complete the project and collect receivables?
5. Are you properly managing your debt so that you are prepared for changes in rates?
Neither Jay, nor I, nor Ben Bernanke knows when interest rates are going to change, how fast or how much (but I did stay at a Holiday Inn Express last night President Obama, if youâ€™re interested). I do know a few things however:
- The Fed has not changed the Fed Funds Rate;
- The Fed has only indicated that it might begin to back off on Quantitative Easing at a deferred date;
- Twenty year Treasury Bond rates have moved up 34 basis points so far this year: http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield ;
- The average rate for a 30-year fixed mortgage rose to 4.46 percent from 3.93 percent, the biggest one-week increase since 1987, McLean, Virginia-based Freddie Mac said in a statement. These are considered the SAFEST loans a bank can make;
- What do you suppose rates on business loans are doing?
It is possible that the Fed has lost whatever control/influence it may have had on rates. The market may be taking over on setting what rates will be going forward. Please consider these factors as you contemplate your business strategies, which will inevitably culminate in an ownership transfer, hopefully on YOUR TERMS!