June 4

Interest Rates Impact on Business Valuation

Interest Rates and WACC


Weighted Average Cost of Capital or WACC is a key tool to value businesses.  WACC is used to discount the future cash flows of a business to present value.  WACC represents the cost of capital to a business. It represents the rates of return demanded by debt and equity capital providers to a business, each weighted by the relative size of investment in the business.


Businesses have access to two types of investors:  Debt capital providers and equity capital providers. Investors to a business have expectations of a return on and of their investment.  Depending on the type of investor, the business will need to return the investors initial investment and provide a return on the investment. 

Capital providers, both equity and debt, have choices for the use of their capital.  Investors expect a return of their investment. Investors will seek the highest return on their investment commensurate with the risk in the investment.

Interest rates are a key component of WACC.  In the equity weighting component of the cost of capital, current interest rates are reflected in the risk-free rates of return. This reflects the rate of a riskless investment, like a short term Treasury Bill issued by the Bank of Canada or a GIC  (Guaranteed Investment Certificate).  In the debt weighting component of the cost of capital, current interest rates are directly reflected in the cost of borrowed money. 

Understanding WACC

For business valuation purposes, WACC is calculated through the following formula:

WACC = {(E/V) * Re} + {(D/V) x Rd x (1-T)}


  • E/V is the percentage of equity capital invested in the business,
  • D/V is the percentage of debt capital used to fund the business.
  • Re and Rd are the required rates of return demanded by the equity capital providers and debt capital providers. 
  • The (1-T) alters the required rates of return of the debt capital providers to the reflect the after-tax cost of debt to the business.  The after-tax cost of debt reflects the tax benefit a business receives by using debt to finance its operations.

Since a business uses both equity and debt to finance its operations, the WACC is a single formula that represents both the equity capital providers and the debt providers and their rate of return expectations.

The WACC is applied to the future cash flows of a business to discount these values back to present value.  This uses a concept known as the “time value of money” in which the value of cash today is worth more than the same amount of money in the future.  More about this idea can be found in this article: Owning a business is like winning a lottery | Troy Valuations (troyvalue.com)

Components of WACC

Equity capital providers and debt providers have different expectations for the return on their investment in a business.  Debt providers have explicit terms for the return of their investment and the return on their investment.  Debt providers know exactly how much and when they will receive the payments that reflect the return of their capital and the return on their capital.  As a result, the debt providers accept a lower rate of return because the returns on and of their capital is explicit.

Equity capital providers in privately held businesses generally do not see a return of or on their investment until the sale of the business.  As a result, equity capital providers in small and medium sized private businesses accept a much higher risk in their investment.  They will therefore have a higher expectation of their return on their investments.

In contrast, equity capital providers in publicly traded businesses have the ability to sell their shares relatively quickly and easily. These investors do not need to wait until the business is sold before they can get a return of the capital.

Return of and Return on Investments

Each type of capital provider not only expects to recover their initial outlay—termed ‘return of investment‘—but also seeks a ‘return on investment.’ For debt providers, this return consists of interest payments on the principal lent to the business. Equity investors, particularly in private companies, accept higher risks in anticipation of substantial returns, typically realized through significant business events like a sale. These returns are neither guaranteed nor predictable, highlighting the speculative nature of equity investments in privately held firms.

Both debt and equity providers actively monitor the performance of the business and prevailing market conditions to adjust their return expectations. Stable or improving business performance over time reduces perceived risks and can influence ongoing investment decisions.

Impact of Interest Rates on WACC

There is a direct relationship between the central bank interest rates and the cost of debt. This can be seen through the amount of media coverage whenever the Bank of Canada or the Federal Reserve Bank in the United States plan to disclose their projections for interest rate changes. Mortgage rates and other borrowing rates adjust following these widely publicized interest rate changes.

The central bank rate effects WACC through two means.  The central bank rates affect the risk free rate of return for the equity capital providers and the interest rate used in the required rate of return by the debt capital providers.

If the central bank raises interest rates, then the debt capital providers will demand a greater return on their investment in the private company, because the capital providers have choice of where to invest.  Similarly, the equity capital providers will also seek a higher rate of return on their investment, with the knowledge that a risk-free investment alternative with a higher rate is now available.

If the central bank lowers interest rates, then the existing debt capital providers will receive a premium return on their investment in the private company.  But new capital providers will adjust their expectations of the lower cost of debt and reduce their required rates of return on the investment. Although the effect is delayed, the equity capital providers will see a lower rate of return on their investment, with the knowledge that a risk-free investment alternative with a lower rate is available.

Managing Expectation sand WACC

Interest rates play a pivotal role in shaping the Weighted Average Cost of Capital (WACC), which in turn influences business valuations. As we’ve explored, changes in central bank interest rates directly affect the cost of debt and, subsequently, the WACC. This relationship underscores the importance for business owners and investors to stay informed about interest rate trends as they dictate the cost of capital and influence investment decisions.

In volatile economic times, understanding the dynamics of WACC can empower businesses to make strategic decisions that align with their financial goals and market conditions. Businesses that adapt their financial strategies in response to changes in WACC can better position themselves for sustainable growth and profitability.

Stay tuned for our next article where we’ll examine the strategies businesses can employ to manage their WACC effectively in response to fluctuating interest rates, ensuring they remain competitive and financially sound in the ever-evolving economic landscape.

Explore Your Business Valuation Options with Troy Valuations

Navigating the complexities of business valuation and capital costs can be challenging. If you’re seeking expert guidance tailored to your business needs in Calgary, contact Troy Valuations. Our experienced team of business valuation experts in Calgary and Western Canada is dedicated to providing insightful and accurate business valuations that help you make informed decisions and drive your business forward. Reach out to us to discover how we can support your valuation and contribute to your business success.


Business valuations Calgary, business value, Fair Market Value, Value

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