All of us are well versed in the traditional theory behind the cost of capital. In fact we’ve got it pinned down into a relatively straightforward formula, the Capital Asset Pricing Model (CAPM). This is briefly described in table one below.
But does CAPM provide an answer to the true cost of capital for the business? Put simply, no.
CAPM provides an expected rate of return for the owners of shares in a business, but not for the business itself when it is allocating its own capital.
Intuitively we know that a capital investment in a promising project within the business must hit a higher rate of return than that which the external shareholder demands from holding shares in the business. The shareholder benefits from huge diversification arising not only the numerous projects that the business itself invests in, but also by being able to invest across a great many different businesses. Diversification reduces risk but also reward. Sanitised by this diversification effect, CAPM (often aggregated with cost of debt to produce a Weighted Average Cost of Capital or WACC) is not a true reflection of the rate of return the business should demand from its own investments in real economy assets.
The true cost of capital is not CAPM for capital reinvested within the business for two reasons:
- The stock market itself sets a price of equity within business far higher than CAPM
- A comparison of the financial versus real economy market characteristics makes it clear arbitrage, and therefore greater risk and reward is present in the real economy.
Table two looks at the FTSE 100 as a whole and walks us through some simple logic leading to the conclusion that the average constituent must make a return on its reinvested equity at a level slightly higher than 13%.
A sensible overall cost of equity for “holding the market” derived from CAPM however, could be around 8%. Therefore, the FTSE 100 is doing something extremely important. It is telling its constituent businesses that they must make a return on retained equity of 13% to maintain the current price to earnings ratio. Shareholders by comparison expect an average return of around of 8%.
If you are still not convinced, then let’s think about how the FTSE 100 and real economy markets differ from each other. The London Stock Exchange is close to being a strongly efficient market. Information is disseminated across trading platforms almost instantaneously. Arbitrage barely exists as algorithms scan for any pricing inefficiency and eliminate it almost immediately. Capital can flow freely, with barely any transaction costs, and is available in almost limitless supply. This type of market lends itself to the statistically derived CAPM formula.
The market that the business operates in the real economy is very different. Information is often not widely available, arbitrage is embedded and opportunities to create value arise from human capital, infrastructure, intellectual property, natural resources, tax and regulation, geographical location and even the weather. It is a core function of business to go hunting for arbitrage, allowing it to use its particular strengths to create value and derive much higher returns than can be gained from investing in the stock market. We call this process strategic planning.
Lastly, resources such as cash and management time are constrained as capital for investment usually only comes from internally generated cash flows. In this very weak form efficient market a different way of setting return targets is required. Fortunately the very efficient stock market values the very inefficient real economy, and this allows us to determine the true cost of capital within the business.
How to determine the true cost of capital
Table two shows a simple process for arriving at an overall cost of equity from the FTSE 100. But as treasurers we deal in cash and not equity. Businesses are valued from the cash they generate now and are perceived to be able to generate in the future.
A business’ value can be broken down into two components:
- Current Worth based upon today’s level of sustainable cash generation.
- Growth Potential – Effectively the difference between its market capitalisation and its current worth.
We can determine the true cost of capital for the business in a three-stage process. Table three walks through these stages based still on the FTSE 100 and is described below:
Stage A: Determine the value of the growth potential of the business
A business has a sustainable current cash flow of 70 and a cost of equity of 8%. The present value of a future stream of cash flows of 70, at a rate of return of 8%, is 875. This is the business’ current worth. However, the stock market has arrived at a market capitalisation of 1,770. The difference of 895 is the growth potential of the business.
Stage B: Determine the increase in sustainable cash flow that justifies the growth potential
Our growth potential of 895 represents the stock market’s estimation of the total positive net present value the business will create from its investing activities in the future. We need to break down this value into an annualised amount and then further into an incremental sustainable cash flow target for each year. We do this by dividing it by a factor of 12.5 (this is our capitalisation factor) producing a figure of 72.
The cost of the invested capital must also be covered, and if we assume that this is 70, the total present value of our cash inflows our investment must produce are 142. Our next step is to derive the incremental sustainable cash flow which produces a present value of 142. Fortunately, again our capitalisation factor of 12.5 allows us to arrive at a figure of 11 for this.
Stage C: Deriving the True cost of capital
The last step is to take this annual cash flow of 11 over the capital investment of 70, giving us a true cost of capital of just under 16%. I have called this true cost of capital Modified Weighted Average Cost of Capital or MWACC.
Our example is summarised in table three above. Although a multi-stage process in essence we have calculated that if the business can meet its MWACC target rate of return of 15.7% on capital invested of 70 it produces a cashflow of 11. Capitalising this as a continual stream of income gives this a value of 142, and once the cost of the capital invested is deducted the net present value of this income stream is 72. The business can repeat this process every year creating a string of “72s”. These add up to the value the stock market has assigned to the growth potential of the business of 895.
Heads may be hurting at this point so let’s leave things there. Next time round we will explore MWACC in some more detail answering some Q&A arising from the concept, looking at what it can tell us about the valuation of a sample of listed businesses and how it can be used within a business to allocate capital efficiently and transform the budgeting process.