This past summer, 606 finance professionals took part in the 2017 AFP FP&A Survey. Tucked away inside the survey were four questions that represent a tangent to the main thrust of the survey about the cost of capital (CoC). Like the survey itself, the questions strive to depart from the detail and calculation of CoC, and instead ask how CoC is being used on a daily basis by finance practitioners.
Why CoC Matters
Start with the premise that capital is a scarce resource, and that each possible use of that capital has an associated level of risk of loss and a level of potential benefit (reward). Capital returns that are further out are higher risk than those which are closer. Those investing their capital will look at the expected risk associated with the potential reward when making their decision.
Here is a quick example: Assume marketing has presented two different product proposals, each of which is expected to create a cash flow over time equivalent to $1 million nominally. Are the proposals equivalent? What if Product A was a feature enhancement on an existing product in an existing market that would deliver its million dollars in three years, while Product B was a new concept to be sold to a different customer set, in a different market, and is expected to return $1 million over 10 years.
Obviously, Product B’s risk is higher, and the expected million dollars is not equivalent to that of Product A. Therefore, the financial analyst would discount the cash flows by applying the cost of capital to better compare the two projects; the cost of capital equalizes different prospective cash flows to allow for risk being taken. (For simplification, we will assume that CoC is interchangeable with the weighted average cost of capital, or WACC.)
The survey asked four questions about CoC, and the responses indicate that most enterprises apply a less rigorous approach and application to CoC.
|Question: How many different costs of capital are used in your company?|
|None, we do not use cost of capital||30%|
|One, we apply the same cost of capital to all investments / projected cash flows||47%|
|Two or more||23%|
Nearly a third of respondents do not use a cost of capital. Diving into the data, this number is heavily weighted by company type, as 50% of non-profits and governments and 39% of companies with revenue under $1B do not use CoC.Publicly-traded entities use CoC much more extensively, likely because it is easier to calculate elements of CoC for publicly-traded stocks, and because equity research analysts and bankers use CoC to compare stock returns and make investment recommendations. These external forces make it easier to apply CoC internally.
|Enterprises that do use CoC tend to use one number for the entire company (true across all demographic breakouts of company types). However, this removes the opportunity for risk stratification through the enterprise—geography, business, market, etc., are all assumed to be equivalent. Therefore, the only internal benefit gained in the application of CoC is timing of cash flows.|
|Question: How frequently does your company review and if necessary, update its estimates of its weighted average cost of capital?|
|Monthly, Quarterly, Semi-annually||22%|
|The fact that such a high percentage of respondents review their COC less than annually is surprising. Risks change over time, and the expected values should reflect that. For example, the cost of capital is impacted by interest rates, company risk relative to the market, and the mix of debt to equity (then, technically, we are discussing the weighted average cost of capital). These elements are in flux constantly. This is consistent with the previous question that shows that internally, the primary value in how enterprises are applying cost of capital is to assess the time value of money|
|Other than cost of capital, how do you risk-adjust your budget? (select all that apply)|
|Probability of success||39%|
|Conservatism factor (reduction to revenue)||54%|
|Cost cushion (build in extra cost or time)||48%|
|Companies are adding risk adjustments to the cash flows themselves in addition to, or in lieu of, using a discount rate. They are adding “haircuts” or building in a cash cushion to protect the net returns. An enterprise choosing these steps needs to manage through certain challenges, most notably consistency. Are these other risk management forecast techniques applied consistently and rigorously? If we are trying to compare NPVs or IRRs across multiple products or businesses, do we know that they are applying the same cushion, by percentage or absolute amount? Or is probability applied due to technical challenge, market familiarity, or other criterion? Is the risk “double-counted” if you include a CoC as well?|
|Question: Which types of cost of capital do you use? (select all that apply)|
|By geography (i.e., country)||34%|
|By business line / at the business level||70%|
|By product / at the product level||36%|
|Not every enterprise is large enough to have multiple geographies, so it is not surprising that most CoC is calculated at the level at business lines and then product level, i.e., the engagement to customers.|
Why is CoC Hard?
Below are factors that may explain why CoC is not rigorously applied inside organizations:
- Public companies can more easily calculate their beta relative to the market, and are scrutinized by equity research analysists and bankers, and therefore are more likely to view this as a market-based metric they can drive internally, even down to lines of businesses and products.
- Private companies need to calculate CoC on their own or find a market-based reference for CoC, which introduces some subjectivity in the matter due to the calculations, and potentially leading them away from CoC. If they have sufficient capital resources, they may not need to apply this metric.
- The commoditization of service and IT via new and cheaper technology means less capital investment is required to launch a company, business or service; investments are made in in people, and therefore may be considered uniform.
- Companies still benefit from the aspect of CoC that values near-term cash flows more than long-term cash flows (“time value of money”).
- Recent market phenomena may have diminished the application of CoC: a decade of stable, low interest rates plus the huge amounts of private equity available means that capital is available at historically cheap levels. The need to discern risk capital is unnecessary when capital is chasing projects.
- Cost of capital has some theoretical components that can be legitimately debated—which equity risk premium should be used? What is your beta, and over which time period is relevant?
- Managing and maintaining a CoC requires effort. The calculation is often subject to debate, changing it during the year requires re-orienting existing projects, changing it requires dissemination across the enterprise and introduces potential “version control” challenges, and juggling multiple CoC’s for different project is open to interpretation and negotiation among managers.