COST OF CAPITAL

Some aspects of the cost of capital, such as the prime rate inflation, and taxes, are fairly evident. The company that must function heavily with short-term borrowing, such as a leasing company or an importer who de- pends upon revolving credit lines, will find itself in serious trouble when the prime rate starts to climb. The company that is fairly heavily leveraged— has a very high debt in proportion to its equity—is also in serious trouble. The expansion-minded company is always viewed in terms of its financial ability to expand either internally or externally. Even in an atmosphere that allows for additional capital through equity, the analyst must consider the cost of a company’s equity capital in terms of its price/earnings ratio. This whole area then becomes a matter of major concern for analysts, and therefore of major concern for the corporation that wants to explain itself.

Increasingly, cost of capital and Capital Asset Pricing Models (CAPM) have become a focus of attention of analysts. In his publication, Valuation Issues, William F. Mahoney writes, “Corporate managements are focusing more on lowering their company’s cost of capital, recognizing its importance to investors seeking to maximize returns of their portfolios.” The goal, he says, is to achieve returns above the cost of capital. There is a great deal of controversy surrounding CAPM as a valid measure of risk, but the models serve as a valuable tool for company financial officers in measuring company performance, and are therefore a valuable element to communicate to analysts.

In Creating Shareholder Value, Rappaport clearly explains that the cost of capital is a crucial factor in deciding whether shareholder value—the worth of the company—is being enhanced. He lists formulas to determine whether a company earns or will earn a return more than its cost of capital. If so, shareholder value is created. If not, no value may be created, or a company’s value might actually go down.

A somewhat similar method of analysis is Market Value Added or MVA. This is the cash investors put into the business over its lifetime, measured against the amount they could get out by selling their stock today. Then there’s EVA—economic value added, which is net operating profit after tax, minus the weighted average cost of capital. Every analyst, it seems, has a preference among ratios. Some may be right. All must be served by the investor relations professional.