This story was published in July 2012.
A company's capital structure -- essentially, its blend of equity and debt financing -- is a significant factor in valuing a business.
The relative levels of equity and debt affect risk and cash flow and, therefore, the amount an investor likely would pay for the company or for an interest in it.
A question that often arises in connection with a business valuation is whether the valuator should use the company's actual capital structure or its anticipated future capital structure. A valuator might also use a prospective buyer's capital structure or the company's "optimal" capital structure. Which method is best depends on several factors, including the type of interest being valued and the valuation's purpose.
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 discount rate.
That rate, which generally reflects the return that a hypothetical investor would require, is derived from the cost of capital, which is commonly based on the weighted average 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 significant financial benefits. Debt is almost always cheaper than equity, and interest payments are tax-deductible. So, as the level of debt increases, returns to equity owners also increase -- enhancing the value of the company.
If risk wasn't a factor, then the more debt a business has, the greater its value would be. But at a certain level of debt, risk associated with higher leverage begins to outweigh its financial advantages.
When debt reaches this point, for instance, investors may demand higher returns as compensation for taking on greater risk, which has a negative impact on business value. The optimal capital structure, therefore, comprises a sufficient level of debt to maximize investor returns without incurring excessive risk.
Identifying a company's optimal structure is a combination of art and science. Valuators may:
Use industry averages.
Examine the capital structures of guideline companies.
Refer to financial institutions' debt-to-equity lending criteria.
Apply sophisticated financial models to estimate a subject company's optimal structure.
Whichever method or methods they use, valuators also 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 realistically 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. 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 generally 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.
Management plans: A company's capital structure fluctuates over time as the value of its equity securities changes and as 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 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.
Matt Stelzman is an accredited valuation analyst and certified forensic financial analyst with Henderson Hutcherson & McCullough where he works in the Specialized Services Group providing business valuation and litigation support services.