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Do You Know
Your Cost of
Capital?
Probably not, if your company is like most
by Michael T. Jacobs and Anil Shivdasani
For article reprints call 800-988-0886 or 617-783-7500, or visit hbr.org
Do You
Know
Your Cost
Of Capital?
Probably not, if your company
is like most by Michael T.
W
Jacobs and Anil Shivdasani
Copyright © 2012 Harvard Business School Publishing Corporation. All rights reserved. July–August 2012 Harvard Business Review 3
Do You Know Your Cost Of Capital?
ducted by the Association for Financial Profession- vidual projects, profoundly affect both the type and
als (AFP), 80% of more than 300 respondents—and the value of the investments a company makes. Ex-
90% of those with over $1 billion in revenues—use pectations about returns determine not only what
discounted cash-flow analyses. Such analyses rely projects managers will and will not invest in, but also
on free-cash-flow projections to estimate the value whether the company succeeds financially.
of an investment to a firm, discounted by the cost of Say, for instance, an investment of $20 million in
capital (defined as the weighted average of the costs a new project promises to produce positive annual
of debt and equity). To estimate their cost of equity, cash flows of $3.25 million for 10 years. If the cost of
about 90% of the respondents use the capital asset capital is 10%, the net present value of the project
pricing model (CAPM), which quantifies the return (the value of the future cash flows discounted at
required by an investment on the basis of the associ- that 10%, minus the $20 million investment) is es-
ated risk. sentially break-even—in effect, a coin-toss decision.
But that is where the consensus ends. The AFP If the company has underestimated its capital cost
asked its global membership, comprising about by 100 basis points (1%) and assumes a capital cost
15,000 top financial officers, what assumptions they of 9%, the project shows a net present value of nearly
use in their financial models to quantify investment $1 million—a flashing green light. But if the company
opportunities. Remarkably, no question received the assumes that its capital cost is 1% higher than it actu-
same answer from a majority of the more than 300 ally is, the same project shows a loss of nearly $1 mil-
respondents, 79% of whom are in the U.S. or Canada. lion and is likely to be cast aside.
(See the exhibit “Dangerous Assumptions.”) Nearly half the respondents to the AFP survey ad-
That’s a big problem, because assumptions about mitted that the discount rate they use is likely to be
the costs of equity and debt, overall and for indi- at least 1% above or below the company’s true rate,
suggesting that a lot of desirable investments are be-
ing passed up and that economically questionable
46 %
5 years
37 %
Current
16 %
90 days
rate on
34 %
10 years
outstanding
debt 5 %
52 weeks
6 % 34 %
Forecasted 12 %
15 years rate on new 5 years
14 %
issuance
46 %
Other 29 % 10 years
Average
historical
rate
4 %
20 years
11 %
30 years
6 %
OTHER
Time periods are for
U.S. Treasury maturities.
Idea in Brief
Companies differ widely in These disagreements matter With trillions of dollars in
the assumptions built into because time horizons, the cash sitting on corporate
the financial models they costs of equity and debt, balance sheets, it’s time for
use to evaluate investment project risk adjustment, and senior managers to have
other factors have profound an honest debate about
opportunities, as a recent
effects—not just on what precisely what affects the
survey by the Association for
companies do with their cost of capital.
Financial Professionals found. investment capital, but on
Not a single question about the ultimate health of those
such assumptions received the businesses and the broader
same answer from a majority economy.
of respondents.
estimate that a 1% drop in the cost of capital leads whereas a software producer uses a much shorter
U.S. companies to increase their investments by time horizon for its products. In fact, the horizon online tool
about $150 billion over three years. That’s obviously used within a given company should vary according Want to test out
consequential, particularly in the current economic to the type of project, but we have found that com- your own data
environment. panies tend to use a standard, not a project-specific,
and calculate your
Let’s look at more of the AFP survey’s findings, time period. In theory, the problem can be mitigated
which reveal that most companies’ assumed capital by using the appropriate terminal value: the number
cost of capital?
costs are off by a lot more than 1%. ascribed to cash flows beyond the forecast horizon.
Go to hbr.org/
In practice, the inconsistencies with terminal values cost-of-capital.
The Investment Time Horizon are much more egregious than the inconsistencies
The miscalculations begin with the forecast periods. in investment time horizons, as we will discuss. (See
photography: Bruce Peterson
Of the AFP survey respondents, 46% estimate an in- the sidebar “How to Calculate Terminal Value.”)
vestment’s cash flows over five years, 40% use either
a 10- or a 15-year horizon, and the rest select a differ- The Cost of Debt
ent trajectory. Having projected an investment’s expected cash
Some differences are to be expected, of course. flows, a company’s managers must next estimate a
A pharmaceutical company evaluates an invest- rate at which to discount them. This rate is based on
ment in a drug over the expected life of the patent, the company’s cost of capital, which is the weighted
11 %
Less than 3%
29 %
One year
30 %
Current book
debt to equity
23 %
3%–4%
13 %
Two years 28 %
Targeted book
49 % 15 %
Three years
debt to equity
5%–6%
23 %
17 %
7% or
41 %
Five years
Current market
debt to equity
greater
2 % 19 %
Current book
Other
debt to current
market equity
average of the company’s cost of debt and its cost of gap is more dramatic. GE, for example, had an effec-
equity. tive tax rate of only 7.4% in 2010. Hence, whether a
Estimating the cost of debt should be a no- company uses its marginal or effective tax rates in
brainer. But when survey participants were asked computing its cost of debt will greatly affect the out-
what benchmark they used to determine the com- come of its investment decisions. The vast majority
pany’s cost of debt, only 34% chose the forecasted of companies, therefore, are using the wrong cost of
rate on new debt issuance, regarded by most experts debt, tax rate, or both—and, thereby, the wrong debt
as the appropriate number. More respondents, 37%, rates for their cost-of-capital calculations. (See the
said they apply the current average rate on outstand- exhibit “The Consequences of Misidentifying the
ing debt, and 29% look at the average historical rate Cost of Capital.”)
of the company’s borrowings. When the financial
officers adjusted borrowing costs for taxes, the er- The Risk-Free Rate
rors were compounded. Nearly two-thirds of all Errors really begin to multiply as you calculate the
respondents (64%) use the company’s effective tax cost of equity. Most managers start with the return
rate, whereas fewer than one-third (29%) use the that an equity investor would demand on a risk-free
marginal tax rate (considered the best approach by investment. What is the best proxy for such an in-
most experts), and 7% use a targeted tax rate. vestment? Most investors, managers, and analysts
This seemingly innocuous decision about what use U.S. Treasury rates as the benchmark. But that’s
tax rate to use can have major implications for the apparently all they agree on. Some 46% of our sur-
calculated cost of capital. The median effective tax vey participants use the 10-year rate, 12% go for the
rate for companies on the S&P 500 is 22%, a full 13 five-year rate, 11% prefer the 30-year bond, and 16%
percentage points below most companies’ marginal use the three-month rate. Clearly, the variation is
tax rate, typically near 35%. At some companies this dramatic. When this article was drafted, the 90-
day Treasury note yielded 0.05%, the 10-year note
yielded 2.25%, and the 30-year yield was more than
100 basis points higher than the 10-year rate.
The Consequences of In other words, two companies in similar busi-
Misidentifying the Cost of Capital nesses might well estimate very different costs of
Overestimating the cost of capital can lead to lost equity purely because they don’t choose the same
profits; underestimating it can yield negative returns. U.S. Treasury rates, not because of any essential dif-
ference in their businesses. And even those that use
the same benchmark may not necessarily use the
same number. Slightly fewer than half of our respon-
Actual dents rely on the current value as their benchmark,
Cost of Forgone whereas 35% use the average rate over a specified
Capital
10% profit
time period, and 14% use a forecasted rate.
Negative
return The Equity Market Premium
The next component in a company’s weighted-aver-
age cost of capital is the risk premium for equity mar-
ket exposure, over and above the risk-free return. In
5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15%
Assumed Cost of Capital theory, the market-risk premium should be the same
at any given moment for all investors. That’s because