What Do Interest Rates Have to Do With It?
So what do interest rates have to do with it? With what, you say? As business valuators, we know well that interest rates can impact the value of a business in a number of ways. The first and most obvious is that the required rate of return (ROR) on an investment in a business rises and falls in relation to the interest rates in the economy. As the ROR increases, the present value of cash flows to the business goes down. The interest rate itself is not an indicator of risk in the investment, which is an important factor in determining a business’s estimated value. It is more a determination of cost of an investment. As pointed out by Ron Dimattia, CPA/ABV, CMA, in an article in the recent Business Valuation Update newsletter, “[t]here are many ways that an analyst can deal with matters of perceived risk in their valuation assumptions.”1 He was pointing out that one of the areas that arguably does not include risk is the determination of the risk-free rate. But we know that rate does fluctuate with changes in the prime rate.2
Of course, the most recognizable impact of changes in the prime interest rate is in the cost to borrow money. As consumers, we know that firsthand. Mortgage rates are higher, credit card rates can go higher, personal loan rates are higher, etc. To the value of a business, this also changes the dynamic and the value. The capital structure of a business is made up of equity investments and borrowing, or leverage. There is a balance between those two elements, and the cost of borrowing can impact that balance. Higher interest rates means less cash flow to equity investors. The lower the cash flow, the lesser the value of the business. With a current prime rate of 8.50% versus years of the prime rate hovering at about 3.25%, one can see that the dynamic in both the value of a business and in how to structure a business has changed.
1 Ronald D. DiMattia, "Practical Considerations in Normalizing the Risk-Free Rate," Business Valuation Update, Vol. 29, No. 10, October 2023; Business Valuation Resources LLC, Portland, Ore.
2 The risk-free rate equivalent is, by consensus, equal to the 20-year yield rate on a U.S. Treasury Bond.