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Probably not, if your company
is like most by Michael T.
Jacobs and Anil Shivdasani
WITH TRILLIONS OF dollars in cash sitting on their balance sheets, corporations have never had so much
money. How executives choose to invest that massive amount of capital will drive corporate strategies
and determine their companies’ competitiveness for
the next decade and beyond. And in the short term,
today’s capital budgeting decisions will influence
the developed world’s chronic unemployment situation and tepid economic recovery.
Although investment opportunities vary dramatically across companies and industries, one would
expect the process of evaluating financial returns on
investments to be fairly uniform. After all, business
schools teach more or less the same evaluation techniques. It’s no surprise, then, that in a survey con-
July–August 2012 Harvard Business Review 119
DO YOU KNOW YOUR COST OF CAPITAL?
ducted by the Association for Financial Professionals (AFP), 80% of more than 300 respondents—and
90% of those with over $1 billion in revenues—use
discounted cash-flow analyses. Such analyses rely
on free-cash-flow projections to estimate the value
of an investment to a firm, discounted by the cost of
capital (defined as the weighted average of the costs
of debt and equity). To estimate their cost of equity,
about 90% of the respondents use the capital asset
pricing model (CAPM), which quantifies the return
required by an investment on the basis of the associated risk.
But that is where the consensus ends. The AFP
asked its global membership, comprising about
15,000 top financial officers, what assumptions they
use in their financial models to quantify investment
opportunities. Remarkably, no question received the
same answer from a majority of the more than 300
respondents, 79% of whom are in the U.S. or Canada.
(See the exhibit “Dangerous Assumptions.”)
That’s a big problem, because assumptions about
the costs of equity and debt, overall and for indi-
The Association for Financial Professionals surveyed its members about the
assumptions in the financial models they use to make investment decisions.
The answers to six core questions reveal that many of the more than 300
respondents probably don’t know as much about their cost of capital as
they think they do.
vidual projects, profoundly affect both the type and
the value of the investments a company makes. Expectations about returns determine not only what
projects managers will and will not invest in, but also
whether the company succeeds financially.
Say, for instance, an investment of $20 million in
a new project promises to produce positive annual
cash flows of $3.25 million for 10 years. If the cost of
capital is 10%, the net present value of the project
(the value of the future cash flows discounted at
that 10%, minus the $20 million investment) is essentially break-even—in effect, a coin-toss decision.
If the company has underestimated its capital cost
by 100 basis points (1%) and assumes a capital cost
of 9%, the project shows a net present value of nearly
$1 million—a flashing green light. But if the company
assumes that its capital cost is 1% higher than it actually is, the same project shows a loss of nearly $1 million and is likely to be cast aside.
Nearly half the respondents to the AFP survey admitted that the discount rate they use is likely to be
at least 1% above or below the company’s true rate,
suggesting that a lot of desirable investments are being passed up and that economically questionable
projects are being funded. It’s impossible to determine the precise effect of these miscalculations, but
the magnitude starts to become clear if you look at
how companies typically respond when their cost
of capital drops by 1%. Using certain inputs from the
Federal Reserve Board and our own calculations, we
Cost of Debt?
RATE ON NEW
TIME PERIODS ARE FOR
U.S. TREASURY MATURITIES.
120 Harvard Business Review July–August 2012
Idea in Brief
Companies differ widely in
the assumptions built into
the financial models they
use to evaluate investment
opportunities, as a recent
survey by the Association for
Financial Professionals found.
Not a single question about
such assumptions received the
same answer from a majority
These disagreements matter
because time horizons, the
costs of equity and debt,
project risk adjustment, and
other factors have profound
effects—not just on what
companies do with their
investment capital, but on
the ultimate health of those
businesses and the broader
estimate that a 1% drop in the cost of capital leads
U.S. companies to increase their investments by
about $150 billion over three years. That’s obviously
consequential, particularly in the current economic
Let’s look at more of the AFP survey’s findings,
which reveal that most companies’ assumed capital
costs are off by a lot more than 1%.
PHOTOGRAPHY: BRUCE PETERSON
The Investment Time Horizon
The miscalculations begin with the forecast periods.
Of the AFP survey respondents, 46% estimate an investment’s cash flows over five years, 40% use either
a 10- or a 15-year horizon, and the rest select a different trajectory.
Some differences are to be expected, of course.
A pharmaceutical company evaluates an investment in a drug over the expected life of the patent,
What’s the Equity-Market
LESS THAN 3%
With trillions of dollars in
cash sitting on corporate
balance sheets, it’s time for
senior managers to have
an honest debate about
precisely what affects the
cost of capital.
whereas a software producer uses a much shorter
time horizon for its products. In fact, the horizon
used within a given company should vary according
to the type of project, but we have found that companies tend to use a standard, not a project-specific,
time period. In theory, the problem can be mitigated
by using the appropriate terminal value: the number
ascribed to cash flows beyond the forecast horizon.
In practice, the inconsistencies with terminal values
are much more egregious than the inconsistencies
in investment time horizons, as we will discuss. (See
the sidebar “How to Calculate Terminal Value.”)
Want to test out
your own data
and calculate your
cost of capital?
Go to hbr.org/
The Cost of Debt
Having projected an investment’s expected cash
flows, a company’s managers must next estimate a
rate at which to discount them. This rate is based on
the company’s cost of capital, which is the weighted
DEBT TO EQUITY
DEBT TO EQUITY
DEBT TO EQUITY
DEBT TO CURRENT
July–August 2012 Harvard Business Review 121
Do You Know Your Cost Of Capital?
A seemingly innocuous decision about what
tax rate to use can have major implications
for the calculated cost of capital.
average of the company’s cost of debt and its cost of
Estimating the cost of debt should be a nobrainer. But when survey participants were asked
what benchmark they used to determine the company’s cost of debt, only 34% chose the forecasted
rate on new debt issuance, regarded by most experts
as the appropriate number. More respondents, 37%,
said they apply the current average rate on outstanding debt, and 29% look at the average historical rate
of the company’s borrowings. When the financial
officers adjusted borrowing costs for taxes, the errors were compounded. Nearly two-thirds of all
respondents (64%) use the company’s effective tax
rate, whereas fewer than one-third (29%) use the
marginal tax rate (considered the best approach by
most experts), and 7% use a targeted tax rate.
This seemingly innocuous decision about what
tax rate to use can have major implications for the
calculated cost of capital. The median effective tax
rate for companies on the S&P 500 is 22%, a full 13
percentage points below most companies’ marginal
tax rate, typically near 35%. At some companies this
The Consequences of
Misidentifying the Cost of Capital
Overestimating the cost of capital can lead to lost
profits; underestimating it can yield negative returns.
5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15%
Assumed Cost of Capital
122 Harvard Business Review July–August 2012
gap is more dramatic. GE, for example, had an effective tax rate of only 7.4% in 2010. Hence, whether a
company uses its marginal or effective tax rates in
computing its cost of debt will greatly affect the outcome of its investment decisions. The vast majority
of companies, therefore, are using the wrong cost of
debt, tax rate, or both—and, thereby, the wrong debt
rates for their cost-of-capital calculations. (See the
exhibit “The Consequences of Misidentifying the
Cost of Capital.”)
The Risk-Free Rate
Errors really begin to multiply as you calculate the
cost of equity. Most managers start with the return
that an equity investor would demand on a risk-free
investment. What is the best proxy for such an investment? Most investors, managers, and analysts
use U.S. Treasury rates as the benchmark. But that’s
apparently all they agree on. Some 46% of our survey participants use the 10-year rate, 12% go for the
five-year rate, 11% prefer the 30-year bond, and 16%
use the three-month rate. Clearly, the variation is
dramatic. When this article was drafted, the 90day Treasury note yielded 0.05%, the 10-year note
yielded 2.25%, and the 30-year yield was more than
100 basis points higher than the 10-year rate.
In other words, two companies in similar businesses might well estimate very different costs of
equity purely because they don’t choose the same
U.S. Treasury rates, not because of any essential difference in their businesses. And even those that use
the same benchmark may not necessarily use the
same number. Slightly fewer than half of our respondents rely on the current value as their benchmark,
whereas 35% use the average rate over a specified
time period, and 14% use a forecasted rate.
The Equity Market Premium
The next component in a company’s weighted-average cost of capital is the risk premium for equity market exposure, over and above the risk-free return. In
theory, the market-risk premium should be the same
at any given moment for all investors. That’s because
How to Calculate Terminal Value
it’s an estimate of how much extra return, over the
risk-free rate, investors expect will justify putting
money in the stock market as a whole.
The estimates, however, are shockingly varied.
About half the companies in the AFP survey use a
risk premium between 5% and 6%, some use one
lower than 3%, and others go with a premium greater
than 7%—a huge range of more than 4 percentage
points. We were also surprised to find that despite
the turmoil in financial markets during the recent
economic crisis, which would in theory prompt investors to increase the market-risk premium, almost
a quarter of companies admitted to updating it seldom or never.
The Risk of the Company Stock
The final step in calculating a company’s cost of equity is to quantify the beta, a number that reflects
the volatility of the firm’s stock relative to the market. A beta greater than 1.0 reflects a company with
greater-than-average volatility; a beta less than 1.0
corresponds to below-average volatility. Most financial executives understand the concept of beta, but
they can’t agree on the time period over which it
should be measured: 41% look at it over a five-year
period, 29% at one year, 15% go for three years, and
13% for two.
Reflecting on the impact of the market meltdown
in late 2008 and the corresponding spike in volatility,
you see that the measurement period significantly
influences the beta calculation and, thereby, the
final estimate of the cost of equity. For the typical
S&P 500 company, these approaches to calculating
beta show a variance of 0.25, implying that the cost
of capital could be misestimated by about 1.5%, on
average, owing to beta alone. For sectors, such as
financials, that were most affected by the 2008 meltdown, the discrepancies in beta are much larger and
often approach 1.0, implying beta-induced errors in
the cost of capital that could be as high as 6%.
The Debt-to-Equity Ratio
The next step is to estimate the relative proportions
of debt and equity that are appropriate to finance a
project. One would expect a consensus about how
to measure the percentage of debt and equity a
company should have in its capital structure; most
textbooks recommend a weighting that reflects the
overall market capitalization of the company. But
the AFP survey showed that managers are pretty
evenly divided among four different ratios: current
For an investment with a defined time horizon, such as a
new-product launch, managers project annual cash flows
for the life of the project, discounted at the cost of capital.
However, capital investments without defined time horizons, such as corporate acquisitions, may generate returns
When cash flows cannot be projected in perpetuity, managers typically
estimate a terminal value: the value of all cash flows beyond the period for
which predictions are feasible. A terminal value can be quantified in several
ways; the most common (used by 46% of respondents to the Association
for Financial Professionals survey) is with a perpetuity formula. Here’s how
First, estimate the cash flow that you can reasonably expect—stripping
out extraordinary items such as one-off purchases or sales of fixed assets—
in the final year for which forecasts are possible. Assume a growth rate for
those cash flows in subsequent years. Then simply divide the final-year cash
flow by the weighted-average cost of capital minus the assumed growth
rate, as follows:
Terminal Value =
Normalized Final-Year Cash Flow
(WACC − Growth Rate)
It’s critical to use a growth rate that you can expect will increase forever—typically 1% to 4%, roughly the long-term growth rate of the overall
economy. A higher rate would be likely to cause the terminal value to
overwhelm the valuation for the whole project. For example, over 50 years a
$10 million cash flow growing at 10% becomes a $1 billion annual cash flow.
In some cases, particularly industries in sustained secular decline, a zero or
negative rate may be appropriate.
HBR.ORG To see how terminal-value growth assumptions affect a project’s overall
value, try inputting different rates in the online tool at hbr.org/cost-of-capital.
book debt to equity (30% of respondents); targeted
book debt to equity (28%); current market debt to
equity (23%); and current book debt to current market equity (19%).
Because book values of equity are far removed
from their market values, 10-fold differences between debt-to-equity ratios calculated from book
and market values are actually typical. For example,
in 2011 the ratio of book debt to book equity for Delta
Airlines was 16.6, but its ratio of book debt to market equity was 1.86. Similarly, IBM’s ratio of book
debt to book equity in 2011 stood at 0.94, compared
with less than 0.1 for book debt to market equity. For
July–August 2012 Harvard Business Review 123
Do You Know Your Cost Of Capital?
those two companies, the use of book equity values
would lead to underestimating the cost of capital by
2% to 3%.
Project Risk Adjustment
Finally, after determining the weighted-average cost
of capital, which apparently no two companies do
the same way, corporate executives need to adjust
it to account for the specific risk profile of a given investment or acquisition opportunity. Nearly 70% do,
and half of those correctly look at companies with
a business risk that is comparable to the project or
acquisition target. If Microsoft were contemplating
investing in a semiconductor lab, for example, it
should look at how much its cost of capital differs
from that of a pure-play semiconductor company’s
cost of capital.
But many companies don’t undertake any such
analysis; instead they simply add a percentage point
or more to the rate. An arbitrary adjustment of this
kind leaves these companies open to the peril of
overinvesting in risky projects (if the adjustment is
Most U.S. businesses
are not adjusting their
investment policies to
reflect the decline in
their cost of capital.
not high enough) or of passing up good projects (if
the adjustment is too high). Worse, 37% of companies surveyed by the AFP made no adjustment at all:
They used their company’s own cost of capital to
quantify the potential returns on an acquisition or a
project with a risk profile different from that of their
124 Harvard Business Review July–August 2012
Michael T. Jacobs is a professor of the practice of
finance at the University of North Carolina’s KenanFlagler Business School, a former director of corporate
finance policy at the U.S. Treasury Department, and the
author of Short-Term America (Harvard Business School
Press, 1991). Anil Shivdasani is the Wachovia Distinguished
Professor of Finance at Kenan-Flagler and a former managing director at Citigroup Global Markets.
Cartoon: Dave Carpenter
These tremendous disparities in assumptions profoundly influence how efficiently capital is deployed
in our economy. Despite record-low borrowing costs
and record-high cash balances, capital expenditures
by U.S. companies are projected to be flat or to decline slightly in 2012, indicating that most businesses
are not adjusting their investment policies to reflect
the decline in their cost of capital.
With $2 trillion at stake, the hour has come for an
honest debate among business leaders and financial
advisers about how best to determine investment
time horizons, cost of capital, and project risk adjustment. And it is past time for nonfinancial corporate
directors to get up to speed on how the companies
they oversee evaluate investments.
HBR Reprint R1207L
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