Business Valuation 607maximize the shareholders’ returns by using a blend of debt financing (less ex-
pensive) and equity capital (more expensive). Say that a prospective buyer of a
business must raise $10 million to acquire the company. If it raised the entire $10
million from the sale of stock, it would have to pay those shareholders a rate of re-
turn of, say, 20%. Or, it could raise a portion of the $10 million by borrowing
from a bank at, say, an after-tax interest cost of 5%. Obviously, the cost of debt is
significantly less than the cost of equity. If management borrows $5 million from
the bank and raises another $5 million through the sale of stock, its overall cost of
capital is significantly lower than if the company raised the entire $10 million
from the sale of stock. This comparison is presented below:
Blended Capital Structure of Debt and Equity
Weighted
Average
Type of Amount Cost of Cost of
Capital ($ million) Percent Capital Capital
Debt $ 5 50% 5% (after-tax) 2.5%
Equity 5 50 20 10.0
Debt and Equity 10 100 N/A 12.5
No Debt in Capital Structure
Type of Amount Cost of
Capital ($ million) Percent Capital
Equity $10 100% 20%The above illustrates that with the proper blending of debt and equity
capital, management can decrease its overall cost of capital from 20% to
12.5%. This has the effect of increasing the shareholders’ rate of return. It also
has a positive effect on the value of the company’s stock.
(This concept of different returns for different types of capital and the
respective weightings is called the band of investment methodolog y when used
in real estate appraisals.)
The relevance of all this to business valuation is that if a particular com-
pany does not already have the proper blend of debt and equity capital, a
valuation may be performed and have an incorrect result unless a more sophis-
ticated debt-free analysis is done. The direct equity methodology does not
take into account an optimal blend of debt and equity (unless the business al-
ready happens to have it). Consequently, the result of a valuation using the di-
rect equity methodology may result in an incorrect value. However, if the
business already has an appropriate blend of capital, the direct equity method
is a simpler valuation methodology and produces a correct value result. In ad-
dition, buyers of smaller private companies do not necessarily take capital
structure into account when making purchase decisions, so a debt-free analysis
may not be necessary for these companies to determine fair market value.
Victoria’s research indicates that ACME does not have the ideal capital
structure. Therefore, she concludes that a debt-free methodology is necessary to