Weighing up the cost of capital

There are two basic ways that a company can obtain finance. It can either borrow it (debt) or raise it from shareholders (equity). But neither banks nor shareholders provide their capital for free, so each method has a cost. A company’s overall cost of capital is an estimate of the combination of these two costs after taking account of their relative contributions. So if a company had twice as much equity as debt, you’d count the cost of debt for a third and the cost of equity for two-thirds. It’s therefore often known as the Weighted Average Cost of Capital or WACC.
A company’s ‘cost of debt’ is relatively easy to calculate. It’s simply the interest a bank charges for the privilege of using its money. The ‘cost of equity’, by contrast, is impossible to pin down. That’s because it’s the return sought by the providers of a company’s equity capital – that is, its shareholders – and investors in the market rarely seem to agree on very much, let alone how much they’re hoping to make from a given opportunity. Before getting back to this, though, let’s take a look at why we’re even bothered about it.
Useful tool
First and foremost, it’s vital for a company’s management to understand its cost of capital, as it sets a minimum benchmark against which investment decisions can be evaluated. And by extension, investors can use their view of the cost of capital as a means of assessing management’s actions.
If a company is generating a greater return on its capital (as measured by the return on capital employed, or ROCE – see last issue’s Investor’s College) than that capital is costing (generally as measured by WACC), then all is well and good and the company is said to be creating shareholder value.
If, on the other hand, a company’s capital is costing more than the returns it’s able to generate, then the company is considered to be destroying shareholder value. That’s the case even if the company is making a profit – the point being that shareholders could be making more profit on their capital elsewhere.
Hotly debated topic
With that, we’d better get back to the knotty problem of the cost of equity. There are various ways this can be calculated, but the most popular, and one of the most stupid in our opinion, is the Capital Asset Pricing Model (or CAPM, pronounced ‘capem’, for short). This is what universities teach economics students, and the trouble is that most of them take it way too literally.
The stupidity that lurks within the CAPM is that it uses share price volatility to calculate the cost of equity, which is to put the cart before the horse to say the least. It might make some sense in the world of efficient markets, where share prices take full and rational account of all available information. But in the real world, where share prices bounce around at the whim of fearful and greedy human beings, it’s about as much use as a chocolate teapot. Imagine a company deciding whether or not to open a new factory based on what its share price did last month. It makes us ill to think of it.
Our preference is for management to set a sensible benchmark for the cost of equity, based on the inherent risk involved in its business. This will help it decide when to reinvest capital or pay it out to shareholders. In other words, we believe the cost of equity should be a hurdle rate that reflects the return a shareholder could expect for the same level of risk in an alternative investment.
WACC in practice
Occasionally a company is brave enough to publish its estimated cost of capital or WACC (unfortunately it’s almost always calculated according to the CAPM). Below is a table showing Foster’s Group’s reported WACC and ROCE between 1999 to 2003. Working backwards from the WACC and cost of debt (obtained from the annual reports), we’ve calculated the cost of equity.

As you can see from the table, Foster’s WACC fell over this period. This was mostly achieved by a reduction in its cost of debt and an increase in the amount of debt used (in theory, and in practice, the cost of equity should go up as a result of more debt – more risk should mean more return). As a result, Foster’s ROCE was consistently higher than its WACC, and theoretically it was creating value for shareholders.
The table also shows why debt is the financing tool of choice – it’s much cheaper than equity. Foster’s average cost of debt for the period was about one quarter its average cost of equity. The main reason for this was the low interest rate environment, particularly in America where Foster’s borrows heavily.
It’s also interesting that 2003 was the last year Foster’s provided an estimate of its WACC. We expect this has something to do with its wine division hitting the buffers in 2004, with ROCE for the division falling from 8.6% to 6.6%. This was well below beer’s ROCE of 31.6% and presumably also well below the company’s WACC.
So, cost of capital is an important but potentially frustrating topic. The solution is to recognise its importance but to be pragmatic about its calculation. If a potential investment falls close to the line, then you (or a company’s management) should probably be looking elsewhere. One of the key questions we ask ourselves about a company’s management is whether it really understands that its equity capital is not provided for free. After all, companies that understand this cost are much more likely to exceed it than those that aren’t.
Tim Searles