Blog: 4.  International Cost of Capital                            Gan Kian Siong ID No: 14045693

Corporate Objectives and Shareholder Value Creation  

Corporate value and shareholder value is created when positive top-line revenues and bottom-line retained earnings are generated (Mauboussin & Rappaport, 2016). Beneath the value-based is when revenues exceed all costs of capital (Gallo, 2016). Shareholders expect management to generate value over and above the costs of resources consumed, including the cost of using capital. Wealth creation refers to changes in the wealth of shareholders on a periodic (annual) basis, mostly from the changes in stock prices, dividends paid out, and equity raised during the period. Since stock prices to reflect investor expectations about company future growth, cash flow, and dividend, creating a wealth of shareholders requires that the firm undertakes investment decisions that have a positive rate of return of the net present value (Arnold, 2013). 

Table 1. The corporate objective of management is to provide consistent and positive shareholders value results from improving cash flow from operations. To minimize the risk associated with the cost of capital by making optimal capital structure decisions is determined by its current performance and to build profitable businesses in the future through shareholder creation (Mauboussin & Rappaport, 2016).

Source: Adapted from Rappaport 1986

Leveraging Cost of Capital

A.  Cost of Capital as opportunity cost to investor which is the expected return on an investment of equivalent risk of corporate allocation funds used to finance the corporate business activities classify in two categories which are cost of equity is financed merely through equity, and the cost of debt which is financed solely through debt (Pratt & Grabowski, 2010). To manage corporate financial risk, companies want an optimal financing mix and the source of fund used both categories of debt and equity to finance their businesses. 

B. The cost of capital use to finance to a company is derived from WACC of all capital sources, typically the cost of capital is used for an evaluation of future discounted cash flow from potential projects and estimate their net present value (Jacobs & Shivdasani, 2012). As the cost of capital representing a hurdle rate that a company must overcome before it can create value, it is extensively used in the capital budgeting process to determine whether the company should proceed with a project.

WACC is used as the discounted rate pragmatically to future cash flow for calculating a business NPV with risk-free rates. WACC could also provide the projected rate of return to both shareholder – equity owners and lenders apply to the net present value return (Jacobs & Shivdasani, 2012). It could also represent the investor’s opportunity cost by accepting the risk appetite amid, despite market volatility, investors would have better choice and confidence spreading the allocation fund into rigor classic capital investment with risk-adjusted returns for business pipelines. 

C. The cost of capital as a hurdle rate for investment analysis is used when a business decides on a capital project, based on the net present value (NPV) approach through the source of capital which is discounted by a determined rate. The value of the discounted cash flow depends on the rate used in discounting the future cash flow then the cost of the project is subtracted to get the net present value of the project.  If the net present value of the project is positive, then the investment is accepted.

              CASH FLOWS   -  COST OF THE PROJECT = NPV

The cost of various capital sources varies from company sizes that matters, the factors such as its operating history, profitability, retained earnings, credit worthiness, etc. For an instant, a newly established company would obtain higher costs of capital due to lack of operating histories than an established company (MSCI Index Research, 2013). Another example, an MNC with larger market capitalization and solid track record with high EPS and free cash flow equip better capital structure.

The cost of debt is the interest rate paid by the company. Debt has tax advantages over equity financing and subsequently interest expenses will be tax-deductible. The after-tax cost of debt is calculated as yield to maturity of debt x (1-T) where T is the company’s marginal tax rate. Nevertheless, too much debt results in high leverage, leading to high-interest rates to compensate lenders for the risk of higher default (Pratt & Grabowski, 2010). For an instant, when a company is conducting capital budgeting, a project is usually evaluated by discounting future cash flow to ascertain the NPV of the project by computing the IRR and compare the hurdle rate (Arnold, 2013). Generally, hurdle rate is defined as the rate for standard projects subject to the divisional risk includes operating risk, financial risk, interest risk and exchange rate risk before any adjustment. 

IRR practice is profoundly determined by the company for investment or financial decision making as a project-based tool as a form of measurement of cash flow analysis, the purpose is to evaluate and determine the co-relationship between its IRR against the minimum required return or cost of capital (Gallo, 2016). For example, if the IRR on a project or investment is greater than the minimum required cost of capital, then the process of decision on the use of capital or fund would generally to proceed with the investment approval, vice versa. In view of financial and investment prospective views, among several projects or investment with the similar degree of risk profile, make go with the one provides highest IRR, the higher the IRR on a project exceeds the cost of capital, the higher the net cash flows to the shareholder and investor.        

Rf – Risk-free rate – Amount obtained from investing in securities considered free from credit risk. Example like government bond and corporate bond.

β – Beta – compares company’s share price reacts the overall market as a whole in price movement. For an instant, company share price is sensitive when market reacted to the news with overbought, oversold before it shares price stabilize.

(Rm – Rf) – Equity Market Risk Premium (EMRP) - it represents the returns investors expects to compensate them for taking an extra risk investing in the share over or above the risk rate.

In principle, financial evaluation process rules used the cost of capital to analyze whether or not to proceed with a project (Jacobs & Shivdasani, 2012). As long as the cost of capital is below the rate of return that the company earns by using its capital, it’s a good investment, vice versa. However, in some business case, it may not be rigidly enforced. For example, a company may pay a very high premium for a merger and acquisition investment with a lower IRR considering other intangible benefits such as tapping into larger economic of scale in an unknown marketplace or company positions to be the market leader as part of the bigger strategic decision or impeding competition.   

Source: Adapted from Rappaport 1986 (concept framework)

Case Study on factors effects projects Cost of Capital Overruns 

According to PWC 2012 and 2013 analysis of 34 companies across multiple industries have revealed that after a public announcement of a capital project delay or shutdown, a majority of companies experience a steady decline in share price by averages 12 percent (PWC, 2013). For an instant, the growth of global construction spending will outpace global GDP growth forecast to reach $12 trillion by 2020, according to Global Construction Perspectives and Oxford Economics.

Source: PwC analysis, The third global survey, based on industry research. 2013

An example, a mega construction projects—those typically defined as exceeding $1 billion—can suffer from many problems, ranging from optimism bias due to cross boarder cultural differences and inadequate communications and too slow decision making. Many owners fail to establish the proper project structure, monitoring procedures, and risk management processes, and as a result, they do not anticipate unforeseen events to build the necessary contingency plans (Andresen, 2006). Because of shortcomings, companies often do not realize the severity of delays and cost overruns until well after a project has foundered. Therefore, corporate governance and the financial capital structure control processes are essential for spotting problems early and getting projects back on track quickly (Frederikslust, Ang, & Sudarsanam, 2008). The effort for companies put in has a greater chance to keep projects in check throughout the construction cycle.

Source: PwC analysis, The third global survey, based on industry research. 2012 

References

1.   Andresen, M. (2006). The process of risk management for projects. GRIN.

2.   Arnold, G. (2013). Corporate Financial Management . Person.

3.   Bohan, O., Josefsen, M., & Steen, P. (2012, July 01). Shareholder Conflicts and  dividend policy. Journal of Banking and Finance.

4.   Frederikslust, R., Ang, J., & Sudarsanam, P. (2008). Corporate Governance and  Corporate Finance. Routledge.

5.   Gallo, A. (2016, March 17). A Refresher on Internal Rate of Return.

6.   Jacobs, M., & Shivdasani, A. (2012). Do you know your cost of Capital? Harvard  Business Review.

7.   Mauboussin, M., & Rappaport, A. (2016, July 01). Reclaiming the idea of shareholder  value.

8.   MSCI Index Research. (2013). Foundations of Factor Investing .

9.   Pratt, S., & Grabowski, R. (2010). The Cost of Capital - Application and Examples (Fourth  ed.). WILEY.

10. PWC. (2013). Correcting the course of capital projects.