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Hello,
"Cost of capital" is the minimum return that investors expect for providing capital to the company. If your business invests in a project that returns less than your cost of capital, the value of your business is reduced. Today's newsletter takes a look at this important concept and offers five insights for understanding what it is and why it matters. Your comments are always welcome. Just click "reply" to send them to me.
Regards,
Charlie Goodrich
Founder and Principal
Goodrich & Associates
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What you need to know about your cost of capital...
And how the Fed's Quantitative Easing might change how you look at it |
In my January newsletter I asked a simple, but important question: Are you really sure you're making money? I explained what the concept means and discussed four areas that are worth probing to better understand which elements - products, customers, divisions, etc. - are contributing (or not) to a business's overall profitability. But, even after better profit measurement, you are still not making money if profits are less than the cost of capital for your business. Today we look at the cost of capital which, simply put, is the minimum return that investors expect for providing capital to the company. If your business invests in a project that returns less than your cost of capital, the value of your business is reduced. If the return from the project exceeds your cost of capital, then the enterprise value is enhanced. How do we calculate the cost of capital? The cost of capital is the amount that must be paid to investors in the form of a return for all equity or stock, as well as all debt, whether that comes from a bond, bank, or alternative source. Usually, businesses look at the cost of capital as a percent. A simple way to calculate that percent is to average the cost of equity and cost of debt, weighted by how much of each is employed. Specifically, to calculate K, the cost of capital:
- D% = Cost of debt expressed as a return
- E% = Cost of equity expressed as a return
- D$ = The dollar value of debt employed
- E$ = The dollar value of equity employed
- K = E% X ((E$/(E$ + D$)) + D% X ((D$/(E$ + D$)
Note that the cost of capital can vary significantly from company to company, even within the same industry. Many businesses will have more components in their calculation as well. Knowing your cost of capital is important. For example, when I worked for Kraft Foods, we bought lots of little food companies with niche brands. We counted on so called "synergy" from the operational benefits of moving production into our more efficient plants and through our dominant sales and distribution system. But was that all really synergy? Or was it simply that with a high cost of capital, many of these projects and expenditures made little economic sense to these small companies, whose cost of capital was much higher than ours? As a modern follow on, Warren Buffett is currently buying Heinz. Can Buffet increase the cash flow of Heinz more than Heinz can itself? Doubtful. But, Berkshire may well have a lower cost of capital then Heinz. Or, Buffet may simply think the market is overestimating Heinz's cost of capital, creating an opportunity for Berkshire's shareholders (unless he's wrong, of course, in which case Berkshire will likely overpay). Five Important things to know about the cost of capital: - Get expert help.
For many readers, I'm sure you've been wondering how I could possibly cover such a complicated and nuanced topic in a brief newsletter. You're right, I can't! There are too many details and considerations involved. On this topic, expertise and experience really matters.
For example, while working in Corporate Strategy & Development for Kraft Foods, I worked on a project to assess our cost of capital. We had just been spun out from what had been Dart & Kraft so an assessment was clearly warranted. The massive buyout of RJR Nabisco by KKR was underway and the price made no sense to us. We thought Pillsbury would be next and we wanted to decide, before that battle began, if we wanted to be a white knight. So we retained two (then new) experts, Marakon and Stern, Stewart, to challenge our assumptions.
You may not be considering such a large deal in your company. Even so, the importance of validating your assumptions and understanding in this area remains high. Here, experts really matter.
- Look to the markets.
A common mistake when evaluating the cost of your debt and equity is to look at historical cost rather than current market cost. For large companies with liquid markets for their stock, the current market cost of equity is relatively easy to discern.
But bonds or debt? Even for large public companies, many bonds often trade between occasionally and never. If your debt and/or equity comes from private sources, than you need private information. Here as well, the experts usually have ready access to this data.
- Use the right time frame.
For the cost of debt component, experts usually suggest looking at 10-year Treasuries as a starting benchmark. Anything shorter tends to understate the cost of capital.
But, what if you plan on selling the business or company in a shorter time frame? Perhaps then, your cost of capital is lower than you think and you are overlooking lower return projects that do in fact make sense. Alternatively, when investing in very long-term assets, a longer timeframe should be considered.
Choosing the correct timeframe will help you make an appropriate decision.
- Make adjustments when straying from your core business.
When investing in something outside your core business look at comparables for businesses similar to that investment (not just your existing business).
The markets for debt and equity value different businesses differently. One sign that the market views an investment differently from your core business is if lenders look at your project as having a different risk profile than your core business.
- Use your judgment.
The right comparables, timeframe, risk adjustments and so forth, require judgment based on your knowledge of your business. While experts are often helpful, they can't replace your judgment.
In today's environment in particular, when governments are manipulating long-term interest rates, you need to get a handle on your true market cost of debt. Data and expertise alone do not replace the need for judgment.
Cost of capital is a complex topic, but one that is essential to understand in evaluating business investments and major decisions. Keep these five guidelines in mind when reviewing your next opportunity.
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| Heard on the Street |
There is considerable debate, both within and outside the Fed, as to whether its latest round of quantitative easing - buying $85 billion of long-term government bonds and mortgages each month funded by sales of short-term Treasuries - can really grow the economy and lower unemployment, particularly without creating large downside risks. In a speech earlier this month. Charles Plosser, President of the Philadelphia Fed, raised exactly these concerns. One of the downsides Plosser is concerned about is that artificially lower long-term interest rates will lead businesses to think their cost of capital is lower than it really is and that businesses will be saddled with investments that return less than their true long-term cost of capital. ( Click here to read Plosser's speech.) Fed Chairman Ben Bernanke countered Plosser's fears in a speech to fellow economists in San Francisco. Here, he directly addresses the question of the Fed's impact on low long-term interest rates and, more specifically, what is known as "the term premium." The term premium is the higher interest rate charged by the market to hold 10-year Treasuries over short-term Treasuries. While Bernanke acknowledges that Quantitative Easing has artificially lowered the term premium, he also believes that some of the lower term premium is because economic growth is expected to be lousy for a long time. What's it all mean? For Heinz, perhaps Buffet believes the market is overestimating the term premium and/or Berkshire's cost of capital is lower than Heinz's. For all of us, it means that determining a company's cost of capital requires more careful consideration, judgment and expertise than ever before!
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| About Us | |
Goodrich & Associates is a management consulting firm. We specialize in helping our business clients solve urgent financial problems. Our Founder and Principal, Charlie Goodrich, holds an MBA in Finance from the University of Chicago and a Bachelor's Degree in Economics from the University of Virginia, and has over 30 years experience in this area.
To ensure that you continue to receive emails from us, please add charlie@goodrich-associates.com to your address book today. Goodrich & Associates respects your privacy. We do not sell, rent, or share your information with anybody. Copyright © 2013 Goodrich & Associates LLC. All rights reserved. For more on Goodrich & Associates and the services we offer, click here.Newsletter developed by Blue Penguin Development |
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