Using Cost-of-Capital Guidelines

How do you determine the minimum acceptable ROR (cost of capital) used in discounting? The cost of capital concept used here is not the same as the cost of borrowing. This is probably the most critical factor in the evaluation process. It is a unique and personal rate to each company. There is no guide to look to in other companies. Two companies looking at a potential investment, say an acquisition, may place two completely different values on it. To Company A, with a minimum required ROR of 10 percent, the investment could be attractive, while to Company B, with a required ROR of 25 percent, the investment would be totally unacceptable. The difference is centered in the cost of capital to each company, its opportunity ROR—the rate that can be expected on alternative investments having similar risk characteristics. An example of the arithmetic involved in reaching this conclusion can be seen when we modify Figure A-2 to include both a 10 percent and 25 percent discount factor and assume that both Companies A and B are the sole potential bidders for an investment with an asked price of \$500 and a net cash flow of \$150 (see Figure A-4).

Year

Cash Flow

(A)

(B)

PV of \$1 @ 10%

Discounted Cash Flow

PV of \$1 @ 25%

Discounted Cash Flow

0

\$(500)

1.000

\$(500)

1.000

\$(500)

1

225

.952

214

.885

199

2

225

.861

194

.689

155

3

150

.779

1 17

.537

81

4

50

.705

35

.418

21

TOTAL

\$ 150

\$ 60 NPV

\$ (44) NPV

Figure A-4: Comparison of NPV using 10 percent and 25 percent discount factors.

The investment is very attractive to Company A but completely unacceptable to Company B—it would realize less than its objective of 25 percent. If Company A were in a position to know the cost of capital of Company B, it would know that Company B would not bid at all for this investment. Company A would know that it would be the sole bidder.

If a company has successfully earned 25 percent on the capital employed in it, an investment opportunity, to be attractive, would have to yield at least that rate. The 25 percent represents the cost of capital to that company, and an investment opportunity offering only 15 percent would be rejected. A second company with a 10 percent cost of capital would find the same 15 percent potential attractive and accept it. Thus the same 15 percent opportunity investment is attractive to one and unattractive to the other. Both companies analyzing the identical situation reach different logical conclusions.

Cost of capital is always considered to be the combined cost of equity capital and permanent debt. We evaluate economic success/failure of a project without regard to how it is financed. Yet we know that money available for investment is basically derived from two sources: debt, with its built-in tax saving so that its cost is half the market price for money (assuming a 50 percent tax rate), and equity, which has as its cost the opportunity cost of capital of the owners.

It is necessary at times to break down the combined cost of capital into its components of cost of debt capital and cost of equity capital to put it in terms understandable to the businessperson who commonly measures results in terms of return on equity. To illustrate this cost of capital concept, we will assume that a corporation is owned by a single individual whose investment objectives are clearly defined. The total capitalization of the company is \$100, made up of \$30 permanent debt capital and \$70 owner's equity capital. If preferred stock was outstanding at a fixed cost, it would be treated the same as debt. The aftertax interest rate of the debt money is 2.75 percent. The aftertax dollar return on the combined debt and equity capital of \$100 under various operations would appear as shown in Figure A-5.

Income on Total Investment (Before Interest)

\$30 Debt 2.75% Cost of Debt Capital

\$70 Equity Income on Owner's Equity

\$ 8.00

\$0.825

\$ 7.175

9.00

0.825

8.175

10.00

0.825

9.175

11.00

0.825

10.175

12.00

0.825

11.175

Figure A-5: Aftertax dollar income on investment of \$100.

To restate these dollars as rates of return on the investment of \$100, \$30 debt, and \$70 equity, the percentage return on capital would be as shown in Figure A-6.

Rate of Return

Cost of Debt Capital

Rate of Return on Owner's Equity

8%

2.75% (\$0.825 \$30)

10.25% (\$7.175 \$70)

9

2.75

11.68

10

2.75

13.11

11

2.75

14.54

12

2.75

15.96

Figure A-6: Aftertax rate of return on investment of \$100.

If the company has been earning an average of \$10 on the total investment of \$100, and the cost of debt is \$.825, the earning on owner's equity is \$9.175. Stated as a rate of return, the \$10 earned on \$100 is 10 percent return on the total investment (combined cost of capital), and because of the leverage built into the capital structure with long-term debt, the \$9.175 earning on equity yields a return on equity of 13.11 percent (cost of equity capital). When there is a 30 percent debt structure and the average cost of debt is 2.75 percent after taxes, we can readily convert return on total investment into return on equity by reading our table. It is quite simple to create similar tables for each company and its debt/equity ratio (e.g., with a 50/50 ratio and debt cost of 2.75 percent, a 10 percent return on total investment yields a 17.45 percent return on equity capital). If there is the opportunity to invest the company funds in alternative situations or reinvest the funds in the business and continue to earn at least 10 percent on the combined debt/equity funds, we would describe this as the opportunity cost of capital. This is the critical rate used in discounting: The discount rate used to determine NPV and the benchmark for comparing DCS-ROR are based solely on the combined cost of capital. The ROR to the stockholders can be derived and compared with their opportunity cost, that is, the ability to invest their funds elsewhere and earn at least the same rate.

Consultative Selling: The Hanan Formula for High-Margin Sales at High Levels
ISBN: 081447215X
EAN: 2147483647
Year: 2003
Pages: 105
Authors: Mack Hanan

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