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 Ron DiMattia, CPA/ABV, CMA, pointed out 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.2 But we know that rate does fluctuate with changes in the prime rate.
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 mean 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.
So why are we talking about this subject? It is pretty basic, isn’t it? Well, yes and no. I was talking to my 36-year-old nephew this morning. He is a managing director at KPMG in the M&A group. I said to him that he probably has never seen interest rates high like this in his lifetime. He admitted that he had not. If he were to ask his mother about high rates, he would find that, when she and his father bought their first house, the interest rate on their mortgage was 17%!
Young people from age 22 to 40 are either starting in business or, like my nephew, already very experienced in business and have never had to deal with interest rate. They are finding out in a hurry that interest rates are a material consideration in valuing, buying and selling, and operating a business in times of volatile changes in interest rates. Welcome to the laboratory of life.
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.