If you have read these posts for a few years, you know that I strongly prefer to value equity interests based on cash flow to them. This lets me directly calculate and demonstrate cash-on-cash return on investment (the third part of the justification of purchase test). It also lets me sidestep using WACC, because I explicitly forecast the level of debt each year.
My financial forecasting model is probably just like yours. Mechanically, we iteratively input the projected level of (short- and long-term) debt each year until cash (the residual that makes the balance sheet balance) is zero or some specified minimum / maximum value. It is the last assumption we input.
If we do it this way, we are making an important implicit assumption: the policy is to minimize debt each year. That is one of many possible strategies:
- The business could be debt-free in the last historical year, might not require any debt in the future, and the control owner may be debt-averse (even though prudent borrowing could increase return on equity, if the cost of debt is less than return on assets). In other words, the business will remain debt-free.
- The business may carry some debt or need some in the future, but the control owner wants to minimize it. This is the strategy outlined in the second paragraph of this post.
- Same as (2), but the control owner wants to maximize it in the short run. By this, I mean the business will borrow as much as it can using an asset-based facility (e.g., 80% of receivables under 60 days, etc.).
- Same as (2), but the control owner wants to maximize it in the long run. By this, I mean the business will borrow as much as it can using both an asset-based facility and term loans supported by fixed assets and cash flow.
These four strategies cover the extremes of from no to maximum debt. Three other possible ones fall somewhere in between the extremes, depending on case facts:
- The business has debt but pays it down as scheduled.
- The business borrows at historical industry averages (say of debt to equity). The problem here is determining whether historical averages will apply to the future and whether they are sensible for the subject.
- Debt levels as specified by the control owner (assuming they are feasible).
In all strategies, we have to consider the control owner’s plans and preferences; they, not the minority owners, decide debt policy. If additional equity capital is going to be needed, we have to consider that as well.
This looks a lot more complicated than it really is! A few on-point questions answered by the control owner will usually narrow down the possible strategies to one or maybe two. In my experience, most business owners opt for strategies 1, 2, or 5, and few (except for real estate owners) opt for 3 or 4. I have never encountered an owner who follows strategy 6, and only a few who follow 7.