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Net Tangible Asset Value: Part 3 - The Value of Leverage

01/09/2010


This is the final step in the 3-part series commenting on the net tangible asset value of a company.

The third, and what is perhaps the least well understood adjustment, the CBV may look at the difference between the existing and the optimal capital structure of the company as at the Valuation Date.  For clarity, a company has two primary sources of capital, debt and equity, and the capital structure is probably best expressed as the debt to equity ratio.

Whether or not this adjustment is made when determining the net NTAV depends upon which of the two available methodologies, known as the enterprise value or the equity methods, is employed by the CBV. Neither method is right or wrong, and each should yield the same value conclusion. It is simply a matter of preference, similar to the use of the direct or indirect method on the statement of cash flows. If the optimization of the capital structure is not considered here (as it is in the equity method), it is factored in when determining the company’s weighted average cost of capital (in the enterprise value method).

All else equal, if the company has less debt then what is considered to be an ‘industry standard’, this has a positive impact on the value conclusion. This value is referred to as the leveraging potential of the company. It is the ability of the shareholder to cause the company to borrow additional funds, without reducing the capital structure below this industry standard amount. These borrowed funds can then be paid out to the shareholder by way of a dividend, repayment of a loan, or through other means.

An example will help illustrate the concept. Let’s assume that you have two identical companies, Saveco and Spendco, which are operating under identical industry and economic conditions. Five years ago, both required a $1,000,000 bank loan to get started, and both negotiated interest only payments for the first five years. After breaking even for the first two years, each company has generated $100,000 of operating cash flows in each of years three, four, and five.

The owner of Saveco took that $100,000 each year and made optional principal payments on the bank loan, while the owner of Spendco took it out as extra salaries and / or dividends. The owner of Spendco probably lives in a nicer house, drives a faster car, has travelled more extensively, or has otherwise consumed that value.  But the owner of Saveco hasn’t lost that value by paying down the bank loan. Rather, it is reflected in the fact that the bank loan for Saveco is now $700,000, while the loan for Spendco is still at $1,000,000. Today, the owner of Saveco has the ability to borrow $300,000 more than does the owner of Spendco, and that ability is worth something. It is the value of that ability to borrow that is the leveraging potential.

From the perspective of the buyer, Saveco has less debt, and as such is a more attractive investment opportunity. Therefore, the buyer should be willing to pay more for Saveco then (s)he would for Spendco, even though their operating cash flows, and the risks associated with those cash flows, are identical. The value attributed to the leveraging potential attempts to quantify this excess.

Of course, the opposite may be true. If the company has more debt then what is considered to be an ‘industry standard’, this would have a negative impact on the value conclusion. Essentially, the company has too much debt, and a prospective purchaser would have to make an equity injection, post acquisition, in order to get the company to that ‘industry standard’ benchmark.

These items can be quite complex, and have been over-simplified for purposes of these articles. In addition to the ‘industry standard’ debt to equity test, the CBV will normally also review debt service ratios and the quantum of the security needed for the additional debt. There are also many non-traditional sources of capital, and the ‘industry standard’ may change significantly over time.

In order to obtain clarification of these topics, including a discussion of how the ‘industry standard’ benchmarks may be identified for your company, please feel free to contact myself or your local MNP advisor.

More From This Series:
Part 1 - Fair Market​ Value
Part 2 - Redundant Assets

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