22 May 2013

What is your cost of capital?

It is a classic rule in economics that, if a proposed investment is expected to have a rate of return that is greater than your cost of capital, you should invest in it. That is a case of marginal benefit over marginal cost. However, there are still too many businesses that do not know what their cost of capital really is — many are probably severely overestimating it.

I am not against adjusting the rate to account for expected risks with respect to particular investment. There are some rules of thumb that have been given in that regard:

  • venture capital investors generally expect an annual after-tax rate of return around 40%
  • angel investors will generally expect at least 50%

There have been other arbitrary rates that have been employed in the past. One company I worked at in the past (which was a part of the Ford Motor Company) expected a minimum return of 15% for any capital investment proposal. As this was back when corporate tax rates were approaching 50%, that meant that before-tax returns were around 30%, which was extremely conservative even in those days when the prime rate was around 11%.

Most good financial management texts have good discussions on the subject of determining a firm's cost of capital, and they all generally agree on the following key points:

  • the emphasis must be on calculating the ideal mix of debt, equity and other financing for the firm
  • the rate will be a weighted average of the returns arising from the different financing components
  • where the firm is privately owned, proxy rates may be employed using data from the industry and the geographic area concerned
  • adjustments for risk may be made for different types of investments, but that is a step subsequent to the initial calculation, and they should reflect the risks faced by the firm in question, as opposed to a blanket adjustment
In these days when many companies have been cutting back on their dividend payouts and capital investments, and interest rates are still around historical lows, "dead money" on corporate balance sheets has been of great concern to many people. The emphasis around such excess liquidity still runs counter to classical economic theory, which holds that excess funds should be paid out as dividends, if there are no alternatives available to earn rates of return in excess of the cost of capital. I would like to see more discussion from corporate executives and analysts as to why that is not the case at this time, or whether this is an extreme case of risk aversion even for Canadian businesses.

No comments:

Post a Comment