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Many businesses have been, are, and will be debt-free…and their owners will sleep well because of it. However, when a business has or will incur debt, its valuation treatment has a huge impact on equity value. In the short run, debt causes earnings and cash flow go down because of interest and principal payments, which leave less money for dividends and reinvestment. In the long run, equity rises as debt is paid off (as it does with home mortgages). These two effects net out differently in every case.
The debt assumption also has to consider whether the equity interest being valued is controlling (and has the power to refinance), what level of borrowing is appropriate for the industry and company, its costs, covenants, and other factors.
High-quality income-producing real estate often generates stable, predictable cash flows that can support high debt, reinforced by stable or growing asset values. At the other extreme, service businesses with few tangible assets and uncertain revenue prospects can support little or no debt. Most businesses fall somewhere between these two extremes.
I have appraised many businesses whose owners had a visceral animus toward borrowing, even though it could demonstrably increase their equity value with almost no risk. In many cases, their aversion to debt was a paramount valuation assumption.
A good business appraisal will consider these factors and present a clear, cogent rationale for the debt assumption and its valuation ramifications.
Valuations play a part in all tax, transaction, and litigation matters. For additional information or advice on a current one, please do not hesitate to call.
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About Western Reserve Valuation Services LLC
Western Reserve Valuation Services LLC, based in Columbus, Ohio, is a leading provider of valuation services and financial opinions relating to corporate finance transactions, corporate tax planning and compliance, succession planning and wealth preservation, employee stock ownership plans (“ESOPs”), financial reporting and portfolio / fund valuations. For more information, visit www.wesresvaluation.com or call (614) 448-3700.
Western Reserve Valuation Services is an affiliate of Western Reserve Partners LLC, a FINRA-member investment banking firm offering financial advisory services relating to mergers and acquisitions, capital raising and financial restructuring. For more information on Western Reserve Partners, please www.wesrespartners.com or call (216) 589-0900.