June 17

Business Management in a Changing Interest Rate Environment

Recently, the Bank of Canada reduced its policy rate from 5.0% to 4.75%.  This period of changing interest rates is important for businesses because it will reduce their cost of capital and expand their opportunities.

Weighted Average Cost of Capital (WACC) is the cost that a business must ‘pay’ or ‘reward’ its investors for the benefit of using their money to fund its operations.  Businesses can borrow from debt capital providers or convince equity capital providers to invest in the business. 

For many small businesses, equity capital providers are the business owners themselves. The debt capital providers are typically the banks, and other lenders, such as leasing companies, shareholder or related party loans.

In each case, the provider of the capital will want a return of, and a return on, the capital.  Debt capital providers offer their loans with the explicit terms determining the timing of the return of the capital.  Businesses will negotiate the term and cost (interest rate) on the capital provided. Equity capital providers delay the return of their capitaluntil the sale of the business.  Both equity and debt capital providers look to the future and the risk of the business to negotiate the expected return on their investment.

In general, the cost of debt is much lower than the cost of equity.  But debt capital providers are much more stringent on the payments restricting a business’ ability to finance both day-to-day operations and long-term fixed asset investments. In the setting of a mix of capital, the business needs to balance the cost of debt with the amount of periodic cash flow. 

In an economy with fluctuating interest rates, the future becomes uncertain.  Businesses and its capital providers should be examining the balance of debt and equity in a business to ensure that the mix is appropriate. This article will examine the reasons and strategies for examining the mix of debt and equity capital in a business.

Adjusting Capital Structure to Optimize WACC

On June 5, 2024, the Bank of Canada reduced its policy rate from 5.0% to 4.75% on both debt and equity costs. The Bank of Canada relied on the decline in inflation as a primary cause for easing the cost of money.  The Bank recognized the return of economic growth in Q1, 2024, strong consumption growth, employment growth, declining wage pressures. While the Bank recognized the cost of shelter is still high, it is watching inflation expectations, demand and supply in the economy, wage growth and corporate pricing behavior.

Over the short term, the decline in the Bank’s policy rate will explicitly reduce the cost of borrowing by businesses. It will also decrease the cost of equity through the decline in the risk-free rate of return.

This is a signal by the Bank of Canada to businesses to adjust their debt to equity ratios.

This is a good time for a business to consider expanding its leverage to take advantage of lower cost debt.  This can be achieved by renegotiating current debt or taking on new debt.  This may be an opportune moment to contemplate expansion opportunities, buying a competitor or investing in new technology.

Long-term Financial Planning with Changing Interest Rates

Business owners should reconsider their business plans in the wake of the Bank’s policy rate reduction.  Forecasting a negotiated rate reduction with lenders should yield higher forecast cash flows.  These higher expected cash flows should enable business to consider expansion plans or reducing their overall debt exposure.

As of the writing of this article, the corporate bank rates have not changed dramatically, but it is expected.  The expected new, lower rates will have the effect of reducing the non-discretionary component of cash flow and increasing the discretionary amount. 

Once the business plan has been revised, business owners should reach out to their lenders. Pre-emptive negotiations with the company’s bankers should provide stronger relationships and lower costs.

If the expansion opportunity exceeds the debt capital availability, the business could consider alternative options like additionally equity financing, venture financing and other creative structures.

Maximizing Business Value in a Changing Interest Rate Environment

Businesses benefit in the wake of the Bank of Canada decisions to the reduce the policy rate.  Borrowing costs will become cheaper making both the cost of equity and the cost of debt. 

Key strategies for business owners include their review of the business plan, update of the financial forecasts and an examination of the amount of cash flow dedicated to discretionary and non-discretionary spending. 

Business owners are encouraged to speak with their lenders, presenting an updated business plan and financial forecast to negotiate a lower cost of debt. Now is a good time to consider expansion opportunities, buying a competitor or investing in new technologies.

At Troy Valuations, we specialize in financial forecasts.  Contact us now to review your business plans and update your financial forecasts.  We will provide a free initial assessment of your business capital structure.  Talk to us about integrating your business operational and financial plans to increase the value in your business.


business value, Fair Market Value, Finance, Troy Valuations

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