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FINANCIALANALYSIS

ARefresheronCostofCapital
byAmyGallo
APRIL30,2015

BABOSCHOKKER

Youvegotanideaforanewproductline,awaytorevampyourinventorymanagementsystem,orapieceof
equipmentthatwillmakeyourworkeasier.Butbeforeyouspendthecompanyshardearnedmoney,youvegotto
provetoyourcompanysleadersthatitsworththeinvestment.Youlllikelybeaskedtoshowthatthereturnonthe
investmentwillbebetterthanyourcompanyscostofcapital.Butareyousureyouknowexactlywhatthatis?And
howyourcompanyusesit?

Tolearnmoreaboutthiscommonlyusedbusinessterm,IspokewithJoeKnight,authoroftheHBRTOOLS:Return
onInvestmentandcofounderandownerofwww.businessliteracy.com.

Whatisthecostofcapital?

Thecostofcapitalissimplythereturnexpectedbythosewhoprovidecapitalforthebusiness,saysKnight.There
aretwogroupsofpeoplewhomayputupthecapitalneededtorunabusiness:investorswhopurchasestockanddebt
holderswhobuybondsorissuesloanstothecompany.Anyinvestmentacompanymakeshastoearnenoughmoney
thatinvestorsgetthereturntheyexpectanddebtholderscanberepaid.

Youmaybewonderingifthisisthesameasdiscountrateandthetermsaresometimesusedinterchangeably,explains
Knight.Thoughthereistypicallyadistinction.Atmostcompanies,thecostofcapitalisamechanicalcalculation
donebythefinancepeople.Thenthemanagementteamtakesthatnumberanddecidesonthediscountrate,orhurdle
rate,thatyouhavetoexceedtojustifyaninvestment,hesays.

Inmanybusinesses,thecostofcapitalislowerthanthediscountrateortherequiredrateofreturn.Forexample,a
companyscostofcapitalmaybe10%butthefinancedepartmentwillpadthatsomeanduse10.5%or11%asthe
discountrate.Theyrebuildinginacushion,saysKnight,whichisnotabadthing.Andhowmuchtheypaditwill
dependontheirappetiteforrisk.Ariskaversecompanymightraisethediscountrateevenfurther,ashighas1520%.
Butifthebusinessislookingtostimulateinvestments,theymightlowertherate,evenifjustforaperiodoftime.

Whatdocompaniestypicallyuseitfor?

Therearetwowaysthatcostofcapitalistypicallyused.Seniorleadersuseittoevaluateindividualinvestmentsand
investorsuseittoassesstheriskofacompanysequity.

FURTHERREADING Letslookatthatfirstinstance.Awisecompanyonly

HBRTOOLS:Returnon investsinprojectsandinitiativesthatexceedthecostof
Investment capital,saysKnight.Sooncethefinancedepartment,
FINANCE&ACCOUNTINGTOOL
byJoeKnight CFO,ortreasuredepartmenthasdeterminedwhattherate
$29.95 ADDTOCART is,managersknowthatisthenumbertobeatiftheywant
S AV E S H A RE towinsupportfortheirprojectsorproposals.Ifyoumake
investmentsthatdontgetareturnthatexceedsthecostof
capital,youreencouraginginvestorstogoelsewhere,
explainsKnight.Yourebasicallysayingthatwerenot
gettingthereturnyouexpected.Thereforeitsimportant
thatmanagersoftenwiththehelpoffinancetakeacloselookatpotentialprojectstomakesuretheyexceedthe
costofcapital

Nowforthesecondinstance.Althoughthisuseislesscommon,investorswilllookatanaspectofthecostofcapital
thebetaorvolatility(moreonthisinthenextsection)whichwillhelpthemunderstandifastockisarisky
investmentornot.

Howdoyoucalculatethecostofcapital?

Inreality,fewmanagerswillevermakethiscalculation.Thisisthejoboffinanceprofessionals,saysKnight,and
totheaveragemanagerwhatgoesintodeterminingthecostofcapitalcanoftenbeopaque.Heresabriefoverview
(basedontheexampleinKnightsbook,FinancialIntelligence):

Thefirststepistocalculatethecostofdebttothecompany.Thisisprettystraightforward.Youtakeallofthemoney
thatthecompanyhasborrowedandlookattheinterestratesyourepaying.Soifthecompanyhasacreditlinewitha
rateof7%,alongtermloanat5%,andbondsthatitusestomakeacquisitionsat3%,youaddthatallupandcalculate
theaverage.Letssayits6%.Thenbecauseinterestondebtistaxdeductibleyoumultiplyitbythecorporatetaxrate
(whichisusuallyaround30%intheU.S.).Theformulalookslikethis:

Costofdebt=averageinterestcostofdebtx(1taxrate)

Soyoutakeyour6%andmultiplyitby(1.00.30).Inthiscasethecostofdebt=4.3%.

Now,setthatnumberasideandmoveovertotheequitycalculation.Thisisamuchmoretheoreticalnumberandtakes
intoaccountbeta(risk)andprevailinginterestrates.
Theformulalookslikethis:

Costofequity=riskfreeinterestrate+beta(marketrateriskfreerate)

Betameasuresthevolatilityofthecompanysstockcomparedtothemarket.Thehigherthebeta,theriskierthestock
is,accordingtoinvestors.Ifastockrisesandfallsatclosetothesamerateasthemarket,thebetawillbecloseto1.If
ittendstoriseandfallmorethanthemarket,itmighthaveabetacloserto1.5.Andifitdoesntfluctuateasmuchas
themarket,likeautilityforexample,itmightbecloserto0.75.

Themarketrateistheexpectedreturnonthestockmarketrightnow.Thereistypicallylotsofdebateaboutthis
numberbutgenerallyitfallsbetween1012%.Theriskfreerateisthereturnyoudgetonariskfreeinvestment,such
asatreasurybill(somewherebetween13%).Thisfigurecanalsobedebated.

Letsassumethatthatthecompanysbetais1,thatituses2%fortheriskfreerateand11%forthemarketrate,then
youdgetthefollowingcalculation:

2%+1(11%2%)=11%

Notehowimportantthebetacanbe.Forexample,ifthecompanysbetawas2insteadof1,thecostifequitywould
be20%insteadof11%.Thatsquiteadifference.

Nowthenextstepistotakeyourtwopercentagesthecostofdebt(4.3%intheexampleabove)andthecostof
equity(11%)andweightthemaccordingtothepercentageofdebtandequitythecompanyusestofinanceits
operations.Letsassumethecompanyuses30%debtand70%equitytorunitsbusiness.Soyouddothefollowing
finalcalculation:

(0.3x4.3%)+(0.7x11%)=8.99%

ThisisthecompanysWACC.
Keepinmindthatthisisanumberusedtoevaluatefutureinvestmentssothereisalotofprojectinggoingon.Youre
usingthecurrentstructureofinterestratesandbusinessconditionstocalculateafuturereturnandtheresanimplicit
assumptionthatyourcurrentbetawillbethesamegoingforward.Inavolatilemarket,thatsnevertrue,explains
Knight.Itshardlyanexactfigureandis,infact,averytheoreticalcalculation.Likeeverythinginfinanceitsbased
onalotofestimatesandassumptions.Itmaylooklikeahard,fixednumberbutitsfarfromthat.

Whatmistakesdopeoplemakewhenusingcostofcapital?

Thebiggestmistakemanagersmake,accordingtoKnight,istakingthenumberatfacevalue.Sure,somegrouse
aboutthenumber,claimingthatitstoohighanditlimitstheinvestmentsthattheycanreasonablymake,butmostjust
takethefigurehandedtothembyfinance.Thisisproblematicbecausethecostofcapitalhasabiginfluenceonwhat
youreabletodo.Itsnotsomethingyoushouldjustaccept.Youshouldabsolutelychallengeit,saysKnight.

Herecommendsaskingyourcounterpartinfinance:Whatdidyouuseforcostofequity?Howdidyoucomeupwith
costofdebt?Orwhydoweuse12%asthemarketrate?Youcanmissalotofopportunitieswhenyouhavetohita
higherstandard,Knightsays,soitsworthaskingtoughquestionsandseeingifyoucannegotiatetherate.Whatyou
wanttheratetobewilldependonthetypeofprojectyouretakingon.Forexample,ifyoureamanagerproposinga
wholenewR&Dsoftwareforanewproductthatyouveneverdonebefore,youwanttouseahighnumber,probably
higherthanyourWACC,toshowthatthistypeofriskyinvestmentisworthit.Butifyourorderprocessingsystemis
breakingdownandyouneedanewone,youcanusealowerratesincethisispartofthenutsandboltsinfrastructure
forrunningyourbusiness.Afterall,ifyoudonthaveanorderprocessingsystem,youllbeoutofbusiness.

Anothermistakemanagersmakeistopadthenumber.Theyliketobumpituptobesafe,explainsKnight.Ifthe
corporatecostofcapitalis12%,thenamanagermightthink,Imgoingtouse15%tobeonthesafeside.Butthe
numberlikelyalreadyincludesacushion.Dontupitagainoryouwillbemakingthingsunnecessarilyhardon
yourself.

Whenfinancetellsyouthatyournewprojectorinitiativeneedsareturnthatbeatsthecompanyscostofcapital,its
helpfultoknowwhatthatfigureisandhowitscalculated.Armedwiththisinformation,youllbeabletobettermake
thecasethatyourideaisworththecompanysinvestment.
AmyGalloisacontributingeditoratHarvardBusinessReviewandtheauthoroftheHBR
GuidetoManagingConflictatWork.Shewritesandspeaksaboutworkplacedynamics.Follow
heronTwitterat@amyegallo.

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GustavoAndrade 9monthsago
Verygoodanduseful.Manythanksindeed.

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