Calculating cost of capital: Four principles

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Benchmarks are critical to decision-making. Benchmarks provide the bright line that help decision-makers evaluate performance.

The speed limit on a road provides a benchmark for evaluating driving speed decisions. Lines on a soccer field provide benchmarks for evaluating passing decisions. Normal vital signs of body function provide benchmarks for evaluating decisions on whether to go to the hospital. The benchmarks are critical because without knowing the appropriate benchmark, the decision-maker is unable to distinguish good outcomes from bad outcomes.

Benchmarks are similarly critical for business investment decisions. A decision-maker is unable to evaluate the merits of the investment without a benchmark rate that distinguishes a good expected return from a poor one. The names used for benchmarks of expected investment return include such as names as the hurdle rate, the required return and the cost of capital. Regardless of the name, what is important to good decision-making is that the rate not be arbitrary, but rather be reflective of what truly discriminates good performance from bad.

THE COST OF CAPITAL
The cost of capital is the opportunity cost (or best alternative rate of return) for the funds that investors commit to a business investment. As such, it reflects the best rate of return that investors expect to achieve on investments of similar risk and horizon. Business managers use the cost of capital to establish hurdle rates for investment projects. Such hurdle rates establish the threshold on proposed investment projects for an acceptable expected rate of return. When business managers invest in projects with an expected rate of return higher than their cost of capital, the business creates economic value in that the expected return exceeds the respective opportunity cost return. Conversely, if the rate of return is less than the cost of capital, economic value is destroyed because the expected return on the project is less than what is expected for investments of similar risk.

When an investor considers investing in financial securities such as stocks and bonds, he or she considers both the expected return and risk of the securities. Securities with more risk demand a higher risk premium. The investor invests in securities only when the expected return compensates for the associated risk. Investors expect the same discipline when business managers make real asset investments in new business projects. With such discipline in mind, new business projects are justified only when the expected returns compensate investors for the associated risk.

The cost of capital is thus not arbitrarily defined, but rather set by market forces based on prevailing rates of return that exist in financial markets. Since investors consider real asset investments in the context of prevailing returns in financial markets, financial theory demands that managers set hurdle rates that reflect the prevailing cost of capital.

PRINCIPLES IN ESTIMATING THE COST OF CAPITAL
In estimating the appropriate cost of capital for any investment decision, the following principles provide valuable guidance.

PRINCIPLE 1: GOOD COST-OF-CAPITAL MEASURES FOCUS ON THE OPPORTUNITY COST FOR INVESTORS TODAY.
Suppose that a firm is paying 4 percent on a loan it made three years ago, but interest rates have since risen such that the business would have to pay 6 percent if the loan were extended today. What is the appropriate cost of debt for such a firm? The novice analyst would set the cost of debt at 4 percent, since 4 percent is the actual cost of the debt to the firm. The experienced analyst recognizes that the cost of debt is not intended to measure the actual cost of funds. While it is true that the cost of funds is 4 percent, the cost of debt is intended to more appropriately focus on the opportunity cost of debt holders today; the cost of debt measures the return that debt holders require today. As such, 6 percent is the appropriate cost of debt in this example because it measures the opportunity cost rather than the actual cost of debt.

PRINCIPLE 2: GOOD COST-OF-CAPITAL MEASURES ARE MORE CONCERNED WITH MATCHING THE CHARACTERISTICS OF THE INVESTMENTS BEING EVALUATED THAN THE CHARACTERISTICS OF THE BUSINESS’ PREVAILING DEBT AND EQUITY SECURITIES.
Businesses typically have several forms of debt financing. These forms may include bank debt or publicly traded debt, or include short-term and long-term debt. In establishing the appropriate cost-of-debt capital for the business, it is important that the analyst remembers that one is simply establishing a benchmark with which to compare investment returns. This benchmark is likely to be different than the actual cost of funds.

As an example, suppose that short-term yields are much higher than long-term yields because of short-term inflation. If a business with substantial short-term borrowing is considering an investment proposal with long-horizon cash flows, it would be inappropriate to use the short-term borrowing rate as the cost of debt. This is because the short-term yield includes high inflation expectations that are not baked into the long-horizon cash flows. By including the short-term cost of debt, one may reject projects with value-creating cash flows simply because the business has chosen to finance its operations with short-term debt and not because the project provides positive risk-adjusted returns. The cost of capital is intended to provide the opportunity cost benchmark over the project horizon.

PRINCIPLE 3: GOOD COST-OF-CAPITAL MEASURES CONSIDER THE PREVAILING RISK PREMIUM FOR MARKETABLE SECURITIES OF COMPARABLE RISK TO THE INVESTMENT BEING EVALUATED.
An expected return reflects two components: a nominal risk-free interest rate and a risk premium that rewards investors for the riskiness of the security. To obtain an appropriate risk premium for the investment under consideration, analysts usually use the risk premium observed in the marketplace for investments of similar risk. If one observes the weighted average cost of capital to be 9 percent for firms in a similar business as that of the investment under consideration, a 9 percent return may provide an appropriate risk-adjusted benchmark to use in evaluating investment returns. In debt markets, credit ratings provide one common estimate of the riskiness of bonds. For equity markets, measures of market covariance are a common measure of risk.

PRINCIPLE 4: GOOD COST-OF-CAPITAL MEASURES RELY ON A CAPITAL STRUCTURE THAT REFLECTS THE VALUES THAT INVESTORS FIND RELEVANT.
In estimating the weighted average cost of capital, the weights assigned to debt and equity should reflect the capital structure appropriate to the investment rather than the capital structure the company maintains. For example, because of the interest in making the cost of capital relevant to investors, market-value-based weights tend to be more relevant than book-value-based weights. In certain cases, historical costs and book values may be relevant for judging current market value.

For example, the market value of debt is commonly difficult to assess. In cases in which the market value is expected to differ only slightly from the book value of debt, the book value is commonly used as an estimate of the market value of debt. If, for example, a business has no debt, the associated weighted average cost of capital may be artificially high because of the firm’s choice to forego debt tax shields. In estimating the cost of capital, it is preferable to use the optimal capital structure weights in order to use what the cost of capital is, without any suboptimal capital structure effects.

In other words, it is inappropriate to reject a project simply because a business has an inappropriate capital structure. Investment decisions should be unaffected by capital structure choice. Despite its importance, the optimal capital structure is not an obvious thing to determine. Because of the ambiguity in the appropriate capital structure, it is common to assume that the proxy business maintains the optimal capital structure and to proceed with using the prevailing weights.

The preceding is drawn from the technical note The Cost of Capital: Principles and Practice (Darden Business Publishing), which offers a step-by-step guide on this subject.

[This article has been reproduced with permission from University Of Virginia's Darden School Of Business. This piece originally appeared on Darden Ideas to Action.]