The impact of interest rate changes on a company's value

(Revised text, first published in 2021)

A major concern for entrepreneurs is the best time to buy or sell a business. In recent months we have entered a period of fluctuating interest rates. In such a context, it's useful to ask how a rise in interest rates might affect the value of a business.

In the following example, interest rates vary but all other factors affecting the value of the business remain unchanged. Although this assumption is unrealistic, our aim 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 see the effects directly.

Let's make a few assumptions:

Let's say the Bank of Canada's current risk-free rate is 3%.

The average cost of debt (given the nature of the assets) is 9%. It is possible to finance 50% of the transaction with debt. The acquirer's required rate of return on its investment is 25% after tax, i.e. 28% before tax for this company. 50% of the transaction value would be required as a down payment by the financiers.

The business has generated EBITDA of $300,000 per annum for at least 5 years. The weighted average cost of capital for this transaction is therefore (interest 9% x 0.50) + (capital 28% x 0.50) = 18.5%. To achieve a 25% return, the buyer would pay ($300,000/18.5%) = $1.621 million - or 5.4 times EBITDA.

4 years later

The Bank of Canada's risk-free rate has risen to 5%.

The average interest rate is now 12%. The investor's required rate of return has increased from 28% to 32% before tax.

The company still has an EBITDA of $300,000. All other things being equal, the value of the company would be ($300,000/ ((12% x 0.50) + (32% *0.50)) = $1.36 million or 4.5 times EBITDA.

In conclusion

Changes in interest rates have an impact on the value of a company. In our example we have assumed that all other factors remain the same. It is important to note that the economic movements that affect interest rates also affect the other factors that change a company's value.

For example, when interest rates rise, people save more and the availability of cash decreases, reducing the number of potential buyers in the market and in turn multiplying the positive or negative effect of interest rate changes alone.

If you have any questions about business transactions, please do not hesitate to contact Galion Conseil.