In our previous article on Cost of Capital, we covered the components of the calculation, where to find the data, and comparison to cost of equity and cost of debt. In this second article, we discuss how corporate finance professionals apply the cost of capital in their daily work.
How the Cost of Capital Helps Valuation
Investors often faces the challenge of how to compare different sets of cash flows. For example, from an external perspective, how do you compare the value of companies that range across different sizes, maturities, industries, markets, and management? From an internal perspective, how do you select projects with many of these same variables?
You can view both companies and their component projects as cash flow streams, then apply a net present value calculation using the cost of capital as the discount rate to create a risk-reward trade-off that allows for comparisons.
The challenge of comparing project with different cash flows and time characteristics
|Year 1||Year 2||Year 3||Year 4||Year 5||Year 6||Year 7||Year 8|
When used this way, the Cost of Capital cost of capital helps solve many different kinds of challenges for investors and business managers
- Time value of money. Which would you rather have, $100 dollars today, or the promise of $100 dollars in 10 years? How about $1,000 in 10 years? We understand that risk increases over time, so we value near-term payments more than distant payments due to the eroding effects of inflation, the risk of non-payment, or the option to take the money today and put it to work for the future. The discount rate devalues payments further in the future.
- In the above example, if both projects are discounted by the same cost of capital at 12 percent, Project 2 is preferable with its higher NPV). The variables of time and discount rate have an impact on the NPV; note that if the Cost of Capital is 4 percent, then Project 1 has a higher NPV as cash flows further out become more valuable.
- This analysis enables us to compare projects with very different cash flows on a similar basis.
- Apply across risk: Which is more valuable, a forecasted $100 from an investment in a new international market or $100 from an established market? Cost of Capital can be adjusted for different risks based on where the company operates or product is sold. Emerging markets would have a higher rate than established markets. In the above example, if project 2 is in a new, emerging market, as opposed to a higher, current market, it will have a higher discount rate which would give it a lower NPV; Project 1 is then preferable.
- Standardizing comparisons across assets. Which is more valuable, a marketing campaign that brings in $1000 of revenue, or automation investment that saves $100 of cost? By focusing on net cash flows (revenue less expenses for marketing, and expense savings for infrastructure), or other hard-to-value measures, investments can be standardized across different businesses. If both projects reflect net cash flows to a company, it does not matter that one is revenue based and the other is expense savings, they are compared on their cash flow relative to company capital charge.
- Apply across capital stack: As an investor, is it riskier to have a company or project that has capital contributions that are 0 percent, 50 percent or 100 percent debt financed? The Cost of Capital adjusts to reflect the change in financing mix over time.
Quick aside, always use cash flows for valuation. Accounting returns include non-cash distortions such as amortization/depreciation and revenue recognition.
Are the Cost of Capital and Hurdle Rate Absolute Determinants?
If a project is independently financed, then yes, you may choose to make an investment determination based on whether its return is greater than the cost of capital. This is because the company capital is entirely aligned with the project (independent of other capital uses), such as buying a company (and its capital stack) or investing in a project with its own project financing, such as a joint venture, legal entity or subsidiary.
If you are inside a company and looking at specific initiatives, the answer becomes murkier because a company’s capital is expended over items that drive sales, others that are overhead (the CEO needs to be funded somehow!) Here is a hypothetical portfolio of investment options and how a CFO may think about the investment decision.
|Project||Return metric *||Decision|
|Project 1: Sales||18 percent||Approved, higher than hurdle rate|
|Project 2: Marketing||14 percent||Approved, higher than hurdle rate|
|Project 3: Infrastructure||13 percent||Approved, higher than hurdle rate|
|Project 4: Sales||13 percent||Not approved, other projects are more highly rated|
|Hurdle Rate:||12 percent|
|Project 4: Infrastructure||8 percent||Potentially approve; it is possible that not all returns to an infrastructure project are accounted for|
|Project 5: Sales||8 percent||Not approved; revenue generating projects generally need to have higher hurdle rates|
|Project 4: Marketing test||3 percent||Potentially approve; possible that the strategic or educational benefits are worth the low returns|
|Project X: Regulatory requirement||0 percent||Approved, required for compliance|
|Weighted average portfolio IRR||13 percent||Higher than Cost of Capital, includes growth, infrastructure, strategic and regulatory investments|
[*] Return metrics need to be consistent with the Cost of Capital used. IRR can be compared to WACC, after-tax cash flows (EBIT*(1-tax rate) can be compared to WACC, and return on equity can be compared to cost of equity. Accounting earnings are discouraged due to timing and non-cash treatments.