BUSF_A01.qxd

Gearing

The calculation in Example 16.3 was based on the book values of the assets and

liabilities. It need not be done on this basis. Some current market value would be more

logical, including a value for goodwill, if any. Since the assets concerned here are

presumably purely economic ones, their value should be based on their ability to gen-

erate future benefits. Because of this, there is no reason why the net assets basis should

give us a different value from that of the price/earnings approach.

Economic value (based on ‘free’ cash flows)

The economic value approach is the most logical. It bases the valuation on the dis-

counted (present) value of the estimated future net free cash flowsof the business.

Logical it may be, but it is problematical. Cash flows will be difficult to estimate, cer-

tainly beyond the first year or two. A discount rate will need to be identified, which

poses another problem. It may be possible to base the rate on the average cost of

capital for the industry in which the business is engaged.

In practice, there tend to be differences between the values obtained from each

approach. The dividend yield basis tends to be used to value minority shareholdings

where the potential shareholder will not own sufficient shares to exercise any

influence over dividend policy. Controlling shareholdings tend to be valued on the net

assets, P/E or economic value bases.

Perhaps we should conclude this section by saying that valuing the shares of unquoted

businesses is a highly inexact science – value is in the eye of the beholder. In practice,

the price at which a transfer occurs, or (for tax purposes) is deemed to have occurred,

is likely to be the result of negotiation and compromise between the concerned parties.

16.9 Gearing

In Chapter 11, we suggested that there might be some optimal level of gearing that

balances the tax advantages of gearing against the increased bankruptcy risk that

gearing engenders. Once again the small business is not in a fundamentally different

position from that of the larger one. There are, however, differences that are likely to

have a significant bearing on where the tax/risk balance lies.

The relatively low corporation tax rates that apply to small businesses mean that

the effective relief for interest payments on borrowings is lower for them than it is for

larger ones. This means that the greater tax efficiency of debt financing, relative to

equity funding, does not apply quite so much to small businesses.

As we saw in Chapter 11, financial risk to which capital gearing gives rise tends to

emphasise the effect of operating risk, which will be present with or without gearing.

Business risk is part specific and part systematic. Since small businesses’ shareholders

may not be able to diversify sufficiently to eliminate most of the specific risk, they are

likely to be more exposed to financial risk than their typical large business counter-

parts. At the same time, it appears that bankruptcy risk is higher for smaller businesses.

These two risk points are not linked, except that they are both likely to make small

businesses more cautious about taking on gearing than are their larger counterparts.

A combination of the tax and risk factors tends to mean that smaller businesses

will reach their optimum gearing at a level significantly below that of a similar, but

larger, business.

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