Australian businesses continue to navigate a complex economic environment caused by ongoing impacts of the COVID-19 pandemic, supply chain issues and rising inflation. The risk to macroeconomic stability has prompted the global central banks including the Reserve Bank of Australia (RBA) to tighten monetary policy through increasing interest rates. We have identified below some of the key impacts to current business valuations as a result of market factors and the current economic environment. This includes considerations as to how discount rates, and consequently business valuations, may be affected.
Weighted average cost of capital
A company’s weighted average cost of capital (WACC) is often used as a proxy for the assessed average rate of return required by providers of debt and equity capital to compensate them for the time value of money and assessed risk or uncertainty of the cash flows of a particular investment, weighted in proportion to the market value of the debt and equity capital provided. The WACC therefore comprises the cost of equity and cost of debt, with the cost of equity typically calculated using the capital asset pricing model (CAPM). To explore how a company’s WACC is impacted by the current economic environment, we will examine the components of both the cost of equity and cost of debt.
Cost of equity
Application of the CAPM requires consideration of the risk-free rate, market risk premium, equity beta (the extent to which price reacts against the market as a whole) and other risk factors.
The risk-free rate (as measured with reference to the RBA long-term bond rates) has increased from 1.49% as at 30 June 2021 to 3.66% as at 30 June 2022. This reflects policies applied by the RBA to counter inflation within the Australian economy which has been driven by the upward pressure on prices due to supply chain disruptions, global economic tensions and the strong demand from an increase in consumer savings and government spending during the pandemic. All else being equal, an increase in the risk-free rate will increase an entity’s cost of equity as an input to the WACC.
The market risk premium is the difference between the expected general market return and the risk-free rate and represents the extra return investors demand for an increase in risk. Available data shows a modest decline in the market risk premium which suggests that generally the expected market return has not increased as much as the risk-free rate.
Equity beta will vary by industry, so it is important to gather comparable data to assess the impact on a company’s beta.
Cost of debt
The cost of debt reflects the expected future incremental borrowing cost of a business at a point in time, and typically follows the movements in the risk-free rates and debt market conditions. Therefore, the current incremental borrowing costs of an entity will likely be higher than 12 months ago and will increase the cost of debt.
In summary, the increase in short-term and long-term interest rates in the global and Australian economy during 2022 will impact an entity’s cost of equity and cost of debt and will likely result in an increased WACC for businesses compared to 12 months ago. In terms of business valuations, a higher WACC implies forecast future cash flows will be more heavily discounted and will likely result in lower business valuations. It is important to consider how the application of a higher discount rate in value in use calculations will impact on the impairment assessments of assets such as the goodwill within business units.
If you would like to discuss further how your business may be impacted, please reach out.