Who We Are...

We are delighted to present our first Media Video release. You will be introduced to the Directors at  Robinson Sewell Partners - Brad Sewell and ...

Read More

Free Consultation

Get a free consultation today

Ian Robinson        0448 697 674

Brad Sewell          0427 390 016

Michael Stout       0427 692 418 

Andrew Toole       0437 889 036

Deb Purvis           0409 438 115

David Robertson  0407 697 797

We will provide an assessment of your business needs, and expectations of our service and agree to the scope of work required.

Request your consultation here.

The true cost of EQUITY v DEBT

31 Oct 2016 12:34 PM -

As a business seeks to expand, either to purchase more agricultural land, acquire commercial property or vertically integrate into the value chain, management faces a tipping point on analysing how this expansion is going to be funded.

Traditionally, a private business draws upon the resources of their traditional financier seeking debt finance.  This avenue may have been the standard default position in the past, so it becomes the natural trajectory for the next phase of expansion.

But what happens when the traditional financier becomes stretched in their capacity to support the expansion proposition for reasons armoured within their lending policy guidelines.  Suddenly the terms embedded within a revised borrowing agreement imposes material funding risk to the business via a potential breach of contract generated from the normal seasonality of cash flow.

This inherently restructures funding risk as a higher risk within the business than operational risk.  Mindset of management then naturally diverts to seeking equity partners to complete the transaction.  But what is the true cost of equity versus debt, and what other options are there in the market?

 

Cost of Equity

There are two schools of thought to work through within this discussion.  If you are a third party investor, it is the rate of return required to cover the risk and illiquidity of the investment.  If viewed from the owner’s perspective, then it is the rate of return required to justify the equity contribution.



Generally, in private enterprise, additional equity from the company owners may already be exhausted.  So for the sake of discussion we will focus on third party contribution.

The third consideration is the opportunity cost of inviting third party equity into the business versus alternative funding options.  This necessitates a subjective analysis to determine the holistic impact of third party equity.

 
CAPM Formula for calculating the Cost of Equity

This formula can be applied to any private business. 

Cost of Equity = Risk Free Rate of Return + Beta x (Market Rate of Return – Risk Free Rate of Return)

Risk Free Rate of Return = Interest Rate of Treasuries.  Say 2.10% for example

Beta = a measure of risk.  The higher the volatility of a company’s performance (and hence the prospective adverse impact on valuation), the higher the Beta.

Market Rate of Return = Average Market Rate.  Over the past 80 years it has been around 11% to 12%.

According to Les Coleman from the Finance Department at University of Melbourne, examples of Beta for various agricultural enterprises between 2001 – 2006 are as follows;

·         Broad acres - 0.71

·         Dairy - 0.53

·         Forestry - 1.16

·         Other foods - 1.06

To quantify a diversified portfolio of broad acre cropping, this would equate to a cost of equity of;

2.10% + 0.71 x (12.0% - 2.1%) = 9.10%

Please note, this is based on theoretical portfolio theory (a large sample).  A standalone request for capital would naturally be exposed to concentration (seasonality / management / commodity / liquidity) risk which would, in theory, increase the Beta materially. This could relate to an adjusted cost of equity from 15% to 25%.

 

Measuring Opportunity Cost of Equity

For a business seeking third party equity for expansion, the following considerations need to be applied (under the assumption a farmer seeking to aggressively expand production by acquisition of landholdings).

  1. Dilution of management control.  Third party equity requires an exact meeting of minds in terms of equity management, expense management and operational management within the Joint Venture partnership agreement.  This can be challenging at best.

  2. Loss of wealth creation.  If a $20.0 million dollar farm is purchased on a 50:50 equity split, and farms double every 10 years (assuming an average of 7% p.a. appreciation).  Over a 30 year period, the value of the equity partner’s asset is now worth $80,000,000 ($10m x2x2x2).  The opportunity cost of not owning that land is profound.

 

Alternative Thinking

So if senior debt from the traditional banking system is the cheapest capital in the market (but caps out upon reaching certain thresholds), and equity is the most expensive, what sits in between?

Here the spectrum of the capital stack remains wide open.  This is a more complex discussion that goes beyond the word count of this article.  If it is an area of strong interest, please call us at Robinson Sewell Partners.  But exploring the true cost of debt vs equity is a healthy discussion to have.