Do You Know Your Cost of Capitals

Topics: Investment, Net present value, Tax rate Pages: 17 (3186 words) Published: September 20, 2012

Do You Know
Your Cost of
Probably not, if your company is like most
by Michael T. Jacobs and Anil Shivdasani

July–AuGust 2012
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For arTicLe reprinTs caLL 800-988-0886 or 617-783-7500, or visiT

Do You
Your Cost
Of Capital?
probably not, if your company
is like most by Michael T.
Jacobs and Anil Shivdasani

With trillions of dollars in cash sitting on their balance sheets, corporations have never had so much money. How executives choose to invest that massive amount of capital will drive corporate strategies and determine their companies’ competitiveness for

the next decade and beyond. And in the short term,
today’s capital budgeting decisions will influence
the developed world’s chronic unemployment situation and tepid economic recovery. Although investment opportunities vary dramatically across companies and industries, one would expect the process of evaluating financial returns on

investments to be fairly uniform. After all, business
schools teach more or less the same evaluation techniques. It’s no surprise, then, that in a survey con-

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 Professionals (AFP), 80% of more than 300 respondents—and 90% of those with over $1 billion in revenues—use
discounted cash-flow analyses. Such analyses rely
on free-cash-flow projections to estimate the value
of an investment to a firm, discounted by the cost of
capital (defined as the weighted average of the costs
of debt and equity). To estimate their cost of equity,
about 90% of the respondents use the capital asset
pricing model (CAPM), which quantifies the return
required by an investment on the basis of the associated risk. But that is where the consensus ends. The AFP
asked its global membership, comprising about
15,000 top financial officers, what assumptions they
use in their financial models to quantify investment
opportunities. Remarkably, no question received the
same answer from a majority of the more than 300
respondents, 79% of whom are in the U.S. or Canada.
(See the exhibit “Dangerous Assumptions.”)
That’s a big problem, because assumptions about
the costs of equity and debt, overall and for indi-

Dangerous Assumptions
the association for Financial professionals surveyed its members about the assumptions in the financial models they use to make investment decisions. the answers to six core questions reveal that many of the more than 300 respondents probably don’t know as much about their cost of capital as they think they do.

What’s Your
forecast horizon?

vidual projects, profoundly affect both the type and
the value of the investments a company makes. Expectations about returns determine not only what projects managers will and will not invest in, but also
whether the company succeeds financially.
Say, for instance, an investment of $20 million in
a new project promises to produce positive annual
cash flows of $3.25 million for 10 years. If the cost of
capital is 10%, the net present value of the project
(the value of the future cash flows discounted at
that 10%, minus the $20 million investment) is essentially break-even—in effect, a coin-toss decision. If the company has underestimated its capital cost
by 100 basis points (1%) and assumes a capital cost
of 9%, the project shows a net present value of nearly
$1 million—a flashing green light. But if the company
assumes that its capital cost is 1% higher than it actually is, the same project shows a loss of nearly $1 million and is likely to be cast aside. Nearly half the respondents to the AFP survey admitted that the discount rate they use is likely to be at least 1% above or below the company’s true rate,

suggesting that a lot of desirable investments are being passed up and that...
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