HOW TO CARRY OUT THE INITIAL VALUATION OF AN INTEREST-FREE OR LOW-INTEREST FINANCIAL INSTRUMENT?
Accounting standards for private enterprises (“ASPE”) stipulate that the fair value of a financial instrument whose interest rate does not correspond to market rates is not equal to the cash consideration. In this case, fair value can be estimated as the present value of all future cash flows, using interest rates currently prevailing on the market for a similar instrument (in terms of currency unit, duration, type of interest rate or other factors) with a similar rating (credit quality).
The question is: what discount rate should be used?
Often, an approximation of the interest rate based on the entity’s current borrowings may be acceptable, if the potential differences are clearly immaterial in relation to the financial statements as a whole.
However, if the amounts involved are significant, a more in-depth analysis is required. Without going into all the details involved in determining an interest rate, it’s important to remember that the interest rate on a financial instrument is directly proportional to the risk incurred by the lender.
Common situations involving interest-free or reduced-rate loans (other than those arising from a related-party transaction) are as follows:
- Purchase of an asset financed directly by the supplier
- Purchase of a business financed in part by the seller (balance of sale)
- Loan from a government or municipal agency
- Employee loans
In all these situations, the risk incurred by the lender is very different.
Section 3856, Financial Instruments, specifies that the rate to be used must be the market interest rate for a “similar instrument”. In order to identify a “similar instrument” in a given context and thus determine the rate of return (discount rate) to use, it is relevant to ask the following question: what would be the most likely alternative to finance this amount?
If the alternative is a secured loan from a financial institution, for example, for the purchase of equipment financed directly by the supplier (when the equipment is pledged as collateral), the interest rate to be used is probably similar to the rate the entity usually charges its financial institution for financing its other equipment, to which a few percentage points could be added to reflect the fact that a traditional term loan rarely finances the entire cost of the equipment.
However, if the alternative is subordinated debt or quasi-equity/equity, for example, in the case of an unsecured loan from a government agency, the interest rate to be used is likely to be similar to the rate of return that would be demanded by a venture capitalist. There are several possible models for analyzing an alternative financing method. The model proposed here takes into account the fact that a financial package is probably necessary, and that we need to take into account the risk incurred by the different types of investors who may be involved in such a financial package, and average out the weighted rates to determine the rate of return (discount rate) to be used.
For example, in the case of an unsecured loan from a government agency for $100,000, if the most likely alternative to obtain similar financing consists of a subordinated debt of $40,000 and a down payment (equity) of $60,000 with respective required rates of return of 10% and 15%, then we can reasonably estimate that the rate of return for a similar financing instrument would be 13% ((10% x 40%) + (15% x 60%)).
To assess the interest rates to be used in such a financing package, it is useful to consider the 5 main criteria of a credit analysis: management, cash flow, financial structure, loan conditions and collateral.
Here are a few thoughts on each of the criteria that help inform the choice of an interest rate.
Management:
Does management have a good reputation and a good track record? In other words: does it inspire confidence in a potential traditional lender? If the answer is no, the alternative might be equity and an equivalent rate of return.
Cash flows :
What is the company’s capacity to generate sufficient future cash flows to repay its obligations? The greater the cash flow in relation to debt servicing, the more historically proven and sustainable it is for the future based on the company’s positioning and industry, the lower the rate should be.
Financial structure :
How is risk shared between shareholders and creditors? What is the company’s financial structure? The greater the leverage used, the higher the rate of return required by a creditor. In a context where the percentage of financing is very high, it could be that the financial instrument has the function of filling a gap in the shareholders’ capital outlay. If this is the case, the required rate of return on part of the instrument could be similar to that required for equity.
Loan conditions :
What is the term of the loan and what are the repayment terms? The longer the term in relation to the assets financed, the higher the interest rate.
What are the restrictive clauses? The more control the lender has over the company’s capital management, the lower the interest rate.
What information does the lender require? The closer the lender can monitor his investment, the lower the interest rate.
Guarantees :
What guarantees are given? Are they any good? Is the amount financed in line with the realizable value of the assets financed? Is there a warranty gap? The lower the percentage of financing in relation to guarantees, the lower the interest rate. Conversely, the portion of financing applied to working capital or in excess of the realizable value of guarantees requires a higher return than the guaranteed portion.
Conclusion
By identifying the relevant alternative financing method in a given context, be it a term loan, subordinated debt or quasi-equity/equity, it is possible to obtain a rate of return that reflects the market for a similar instrument.
Of course, as this is an exercise that requires judgment and the use of hypotheses, there will never be a single answer. Proper documentation of the above criteria is certainly the key to success in obtaining an appropriate estimate.
This article was originally published: Site de l’Ordre des comptables professionnels agréés du Québec | Comment procéder à l’évaluation initiale d’un instrument financier sans intérêts ou à taux réduit | 2015-03-17
