Cost of Capital
By Maurie Cashman
The cost of capital for a business is a critical measurement that every business owner should know how to evaluate. It is one of the leading causes of problems in achieving an ownership transition since it is a key in developing reasonable and supportable business valuations. One of the biggest problems that the Pepperdine Cost of Capital Survey finds each year is that owners and buyers have unrealistic ideas about the value of a business, largely because they donâ€™t understand cost of capital.
Cost of capital is also key when I am asked by business owners whether or not I think they should make certain investments in their businesses. These investments have included investing in strawberry production for a traditionally floral oriented greenhouse operation, buying facilities adjacent to a manufacturing plant and buying additional rolling stock for a trucking firm. The answer in each of these cases was initially â€œthat dependsâ€.
One of the dependencies is the cost of capital for that particular business.
What is ‘Cost of Capital’
The cost of capital is defined by Investopedia as the required return necessary to make a capital budgeting project, such as building a new factory, worthwhile. Cost of capital includes the cost of debt and the cost of equity. Another way to describe cost of capital is the cost of funds used for financing a business. Cost of capital depends on the mode of financing used â€” it refers to the cost of equity if the business is financed solely through equity, or to the cost of debt if it is financed solely through debt. Many companies use a combination of debt and equity to finance their businesses and, for such companies, the overall cost of capital is derived from a weighted average of all capital sources, widely known as the weighted average cost of capital (WACC). Since the cost of capital represents a hurdle rate that a company must overcome before it can generate value, it is extensively used in the capital budgeting process to determine whether the company should proceed with a project.
Calculating a companyâ€™s weighted average cost of capital can be very complicated and the cost can vary depending on the capital expenditure being considered. We are not going to dwell on the technicalities involved but rather on what can impact your cost of capital, and what you can do to affect it.
Risk is the key to lowering your companyâ€™s cost of capital. Everything flows from it and everyone investing debt or equity into your business first makes a calculation as to whether or not they believe they will:
- Get their money back;
- Get a reasonable rate of return on their investment;
- Could get the same or better return with less risk by investing elsewhere.
When a bank gives you a business loan, they are looking at the â€œFive Câ€™sâ€ (or their particular branding of these):
Character, Capacity, Capital, Collateral and Conditions.
Score well in their systems on each of these areas and you are likely to be approved for financing upon favorable terms. Score poorly on one or more areas and you may still get the loan, but it will carry a higher interest rate, shorter loan amortization term and other terms designed to either lessen the bankâ€™s risk or increase their return for making a riskier loan.
Investors (which means your buyers, employees and family) are looking at similar risk factors when deciding whether or not they want to own all or part of your business. They may not be as specific in their criteria for evaluation but they are subconsciously making similar calculations regarding risk and return.
Reducing Risk Lowers Cost of Capital
The lower the cost of capital the more attractive your business is to buyers and the more valuable investments in strategic business assets will be. You can influence your cost of capital by reducing risk. Here are some things that I evaluate when developing a companyâ€™sâ€™ cost of capital:
- How consistent are your earnings from year to year? Companies with stable and increasing earnings are seen as less risky since those earnings are generated from a stable business system that may be assumed to be repeatable unless other factors are discovered to contradict that assumption.
- How much leverage do you have? Companies with high amounts of debt will have to invest larger quantities of equity or take on high cost financing in order to grow or replace capital. Equity is generally more expensive than debt and using equity will therefore drive cost of capital higher. Keep a tight rein on your balance sheet so that you can manage your cost of capital.
- What are you investing in? In the examples I cited above, investing in strawberry production was far more risky than investing in a truck. Therefore, the potential return to capital had to be much higher. In evaluating that investment, we had to assume higher equity investments and higher interest rates. Therefore, the cost of capital for that project were much higher than a normal investment in greenhouse assets would have been.
- What is happening in your industry? Is your industry poised for major growth or is it potentially in decline? An investment in Bon-Ton would have carried a dramatically higher cost of capital than a comparable investment in Amazon a few months ago. That is because the competitive dynamics in the industry had changed dramatically away from brick and mortar stores to online fulfillment. You need to understand your industry and your relationship to it.
- What are the particular characteristics of your business? Are you carrying very high levels of accounts receivable or inventory? You may think this is important to your customers or your competitive position but a buyer is unlikely to share your views on this for two primary reasons:
- They are unwilling to shoulder the risk of collecting overdue receivables or selling old inventory that you have been unable to sell.
- They do not want to borrow the money required to finance these assets.
Clean up your current accounts if you want to positively affect your business cost of capital.
These are just a few things that you can start working on to reduce your cost of capital. Some are within your control and some you can only influence. Some may be hard for you to see since you have gotten used to a certain operating style. Consult a trusted advisor to get an outsiders opinion. These factors are important and take time to change so start now.