Many experts believe that low interest rates are here to stay for the foreseeable future. Despite the Federal Reserve’s desire to increase interest rates as expressed by Chair of the Board of Governors of the Federal Reserve System Janet Yellen, a perfect storm of domestic and international events have made another rate increase this year highly improbable. The U.S. economy’s performance when measured by GDP growth and employment is weaker than expected. Increasing interest rates could harm the tepid growth we are currently experiencing. The surprise referendum vote result by the United Kingdom to exit the European Union has created economic and financial uncertainty in Europe. A rate increase here could potentially harm European economies.
A low interest rate environment can be a perfect opportunity for businesses to make certain strategic decisions that could prove too costly when interest rates are high. Decisions made to take advantage of low interest rates can significantly enhance the value of a company’s shares over the long term.
Make Capital Expenditures
Capital expenditures refer to the purchase of physical assets that a business expects to keep for at least one year. They usually add value to the company by reducing the marginal cost of production, increasing capacity or both. There is usually a large upfront cash cost with capital expenditures and most businesses will need to borrow money to make the purchase, therefore the interest rate paid will have a direct impact on the financing cost of capital equipment.
Let’s say a commercial bakery is experiencing tremendous demand and their current equipment is operating at near capacity. In order to serve new customers it needs to purchase $1 million worth of commercial baking equipment that they expect will last 12 years but will be financed over five years with payments due on the first of each month. At an annual interest rate of 5 percent the monthly payment would be $18,871.23 and the total interest paid over five years would equal $132,174.02. The same transaction at 15 percent interest would require monthly payments of $23,789.93 and a total interest cost of $427,395.81. The difference is nearly $5,000 per month in cash payments and over $295,000 in total interest costs. If the bakery operates at a 10 percent profit margin they would need to sell an extra $2.95 million over the life of the equipment just to cover the additional interest costs.
Refinance Loans and Lines of Credit
Low interest rates can also be ideal for refinancing existing loans and lines of credit. Usually there are some upfront costs associated with this type of transaction, but for many businesses the costs are more than justified by the long-term savings.
Using the same numbers as before (5 versus 15 percent interest rate on a five-year, $1 million loan), the total interest cost savings equal $295,000 or nearly 30 percent of the actual amount borrowed. Compared to the upfront refinancing costs, which could equal anywhere from 1 to 4 percent, the savings associated with refinancing even with upfront costs are enormous.
Refinancing isn’t just about interest savings; it’s also about certainty. Many companies have variable-rate loans because they tend to carry a lower interest rate at the beginning. But when rates do increase and the variable-rate loans become more expensive there is no guarantee that the company will qualify for a better loan at that time. So refinancing intro fixed-rate loans represents an opportunity to minimize the risk of being locked into an expensive and ever-increasing loan.
Buy Out Your Partners or Investors
This may be the most lucrative option for leveraging low interest rates. It’s common for business partners to have unaligned interests over time. Perhaps one partner wants to aggressively expand while the other wants spend less time at work and more at home. Or perhaps the business started with money from friends and family who are no longer interested in keeping their capital locked into a company that won’t have a liquidity event for years. These are opportunities to leverage low interest rates to borrow money and use that money to buy out partners and investors.
From a return perspective it’s extremely attractive. Let’s say you need to borrow $1 million to buy out your partner’s 40 percent equity interest in the business and you plan to pay back the loan over five years. The interest costs associated with this transaction total $427,395.81, so the total cost to purchase 40 percent of your company is $1,427,395.81. That values the entire company at nearly $3.57 million. Is it worth more than that? Then it may be a good deal. If companies in your industry sell at 10 times EBITDA for example, then as long as your EBITDA is $357,000 you haven’t overpaid. But think what that 40 percent you bought will be worth in five years after you grow the business? For every additional dollar in EBITDA that you generate you could be earning 10 dollars in value that may flow to your pocket.
Note: For the sake of simplicity in this post, the income tax effect of the additional interest costs have not been taken into consideration as this varies by company and does not change the conclusions.
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