Cost of Capital
In the evaluation of the purchase of any corporate asset
the net present value of the cash flow stream from it has to be compared to the out of pocket cost of
it to determine its acceptability. The principle is fundamental: no corporate investment should be made
where the cash flow stream, discounted by what it costs to get the investment dollars, does not
exceed the investment of those dollars in present value terms. In other words the percentage of return
on the investment must be greater that the percentage cost of the dollars used to buy it.
The fact is that the discount factor employed is key to the
decision. A cash flow stream discounted by 12% will have substantially less value than a cash flow stream
discounted by 10%. Thus what is costs to get the money to buy the asset is a critical calculation in the
efficacy of any corporate investment.
Lets take an example. Lets assume that a company has sufficient
retained earnings to purchase a commercial office building to be rented out. Lets assume that this building
will be held indefinitely and that the net annual cash flows from it are $1,000,000. Lets assume that
the out of pocket cost of the building is $5,000,000. Assume they will use Discounted Cash Flow analysis
to make their decision. If we take a look at the right side of their balance sheet we could see the following:
|Long Term Debt
|Common Stock & Retained Earnings
Notice we have taken the right side of the balance and looked
at it as one large bag of money, each element of which has a different cost. For example, Accounts payable
and Accruals are dollars in our bag which do not have an explicit cost. Notes Payable is short term money
we owe the bank on which we pay 8%, but were allowed to deduct debt cost from our income tax so we adjust
for taxes of 40%. Our Long Term Debt could be other mortgages, the cost of which we also adjust for taxes.
The Bonds, Preferred and Common Stock are sold in markets
and thus we have to compute their market value and percentage cost from the price they are selling for
in those markets. Notice we adjust the return on bonds, which are debt, but do not adjust the return on
the equity securities which are not tax deductible.
Finally, we take each adjusted cost, as a weighted percentage
of the total bag of money. In this case, it costs the company over 13% to compensate each stakeholder
in the bag for all asset investments the company makes. Thus, in order to qualify as an investment,
the cash flows of the office building in question must show a Positive Net Present Value when discounted
by 13%. The value of the right to receive $1,000,000 indefinitely in this case is:
$1,000,000/.13 = $7,692,307.
Clearly, cost of capital and discounted cash flow analysis
show the building as a bargain at $5,000,000. Please note that if it cost this company over 20% for the
money used purchase the building, the purchase of the building would have to be rejected: