Global Strategy- an Organisng Framework

Chapter

R i s k , Co s t of Capi t a l, a nd Capi t a l B ud g et i ng

KEY NOTATIONS

Market value of a firm’s debt CAPM Capital asset pricing model COGS Cost of goods sold Cov Covariance EBIT Earnings before interest and taxes EVA Economic value added IRR Internal rate of return NPV Net present value Cost of debt; a firm’s RB borrowing rate Risk-free rate of return RF Expected return on RM market portfolio Cost of equity RS RWACC Weighted average cost of capital ROA Return on assets S Market value of a firm’s equity Sales, general, and SGA administration costs SML Security market line Corporate tax rate tc Var Variance b Beta B

12

In late 2005 Swiss Re, one of the world’s leading reinsurers, published a report discussing how insurance companies create value for shareholders. One of the key components addressed in the report was the cost of capital. According to Swiss Re, the cost of capital for the US non-life insurance industry during the 1980s was about 15 per cent. By 2005 the cost of capital for the industry had dropped to 7 to 8 per cent. However, the cost of capital is important in more than just the insurance industry. One of the major reasons given for the sale and break-up of Lehman Brothers in 2008 was that the expected lowering of Lehman Brothers’ debt rating would have increased the cost of capital for the company, thereby making business for the bank significantly more difficult. In this chapter we learn how to compute a firm’s cost of capital, and find out what it means to the firm and its investors. We shall also learn when to use cost of capital – and, perhaps more important, when not to use it.

PaRT ThREE

12.1 The Cost of Equity Capital

Whenever a firm has extra cash, it can take one of two actions. It can pay out the cash immediately as a dividend. Alternatively, the firm can invest extra cash in a project, paying out the future cash flows of the project as dividends. Which procedure would shareholders prefer? If a shareholder can reinvest...