One of the benefits of using asset based business valuation methods is that you can see how each business asset and liability contributes to business value. This is very useful for a number of important reasons:
- Estimation of business value for tax purposes.
- Business purchase price allocation.
- Determination of which business assets are available as part of business sale.
To use the well-known asset accumulation method to value your business, you start with the current balance sheet. You then adjust this cost-basis data, accounting for off-balance sheet items and estimating the fair market values of business assets and liabilities. The difference is business value.
One of the important adjustments is determining the value of business long-term liabilities. A typical example is a commercial bank loan. Business management may have negotiated the terms of such financing some time in the past. As financial market conditions change, so do the terms of such loans.
So how can the terms of debt financing obtained awhile ago affect what your business is worth today? Let’s take a look at an example.
Example: favorable financing and business value
Suppose that you have a commercial bank loan with $250,000 balance and a 10 year term at an attractive 4.75% fixed annual interest. Under this arrangement your yearly payment, including both principal and interest, is $31,454.32.
If you were to raise this loan today, your bank would charge you around 7.75% interest. This would mean an annual payment of $36,003.19. By financing debt at the lower 4.75% rate, your business saves $4,548.87 each year.
This effectively lowers the present value of the loan. And since your business value is calculated as the difference between the present values of the business assets and its liabilities, such favorably financed debt works to increase your business worth.
You can account for this business value-enhancing effect of lower cost debt financing as follows:
- Start with your current annual payment of $31,454.32.
- Discount this payment stream at the current market rate of 7.75%.
- Calculate the present value of the debt. This is what the favorably financed loan is worth today.
- Subtract this amount from the fair market value of business assets.
Using ValuAdder Loan Schedule and Discounted Cash Flow calculations you find that, instead of $250,000, the commercial loan is worth only $213,461.86 today. Other things being equal, this contributes $36,538.14 to your business value.