The cost of capital is an important consideration when valuing a business under the income approach. This article explains how business valuation experts determine the “optimal” capital structure for a business and why it matters.

Debt vs. Equity

Shareholders, partners, and other equity investors expect to achieve a certain return in exchange for providing financing to a business. This may come in the form of 1) annual dividends or distributions, and 2) appreciation in the value of the investment. The latter payout comes when the business is sold or its assets are liquidated.

Some business owners strive to be debt-free, but a reasonable amount of debt can provide some financial benefits, particularly for a growing, profitable company. Currently, the cost of debt financing is near historic lows. In addition, business interest payments may be tax-deductible.

It’s important to note that the Tax Cuts and Jobs Act (TCJA) limits business interest expense deductions for tax years beginning after 2017. This change could increase the cost of debt in some cases. However, many private businesses won’t be affected by the limitation. There’s an exception for small businesses (generally, those with average annual gross receipts of $25 million or less). The rules also allow certain real estate and farming entities to elect out of the limitation rules.

Capital Structure

Even with the interest expense limitation, debt is still generally cheaper than equity. 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 had, 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 – and the cost of debt increases.

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. The so-called “optimal” capital structure comprises a sufficient level of debt to maximize investor returns without incurring excessive risk. 

There are several options when choosing the capital structure to use when valuing a business, such as:

• The company’s actual capital structure
• The company’s anticipated future capital structure
• A prospective buyer’s capital structure
• The optimal capital structure for comparable companies
  
  

What’s appropriate depends on several factors, including:

Level of control: If the interest being valued is a controlling interest, it’s often appropriate to use the optimal capital structure. Why? Because a controlling owner generally can change the company’s capital structure and will choose one that yields the most profitable results. If the interest being valued is a noncontrolling interest, it’s customary to use the company’s actual capital structure, because the owner of a minority interest lacks the ability to change how the business is financed. 

Valuation purpose: To estimate fair market value, experts typically use the subject company’s actual, optimal, or forecasted capital structure. But if the standard of value is investment value, it may be appropriate to use the specific buyer’s prospective capital structure.

Changes in business strategy: A company’s capital structure fluctuates over time. 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.

Practical Applications

Capital structure (the relative levels of debt and equity) affects the cost of capital. Generally, when using income-based valuation methods, experts convert projected cash flows to present value by applying a discount rate based on the cost of capital. The higher the cost of capital is, the lower the value of the business interest will be, all else being equal.

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.

Bottom Line

Small changes in the cost of capital can have a major impact on value. A credentialed valuation expert knows how to evaluate the cost of capital based on the unique facts and circumstances of your assignment.