ISBN: 0-03-028931-9

Chapter 10 The Cost of Capital

Creating Value At GE

In Chapter 2 we discussed the concept of EVA – Economic Value Added – which is used by an increasing number of companies to measure corporate performance. Developed by the consulting firm Stern Stewart & Company, EVA is designed to measure a corporation's true profitability, and it is calculated as after-tax operating profits less the annual after-tax cost of all the capital a firm uses.
The idea behind EVA is simple – firms are truly profitable and create value if and only if their income exceeds the cost of all the capital they use to finance operations. The conventional measure of performance, net income, takes into account the cost of debt, which shows up on financial statements as interest expense, but it does not reflect the cost of equity. Therefore, a firm can report positive net income yet still be unprofitable in an economic sense if its net income is less than its cost of equity. EVA corrects this flaw by recognizing that to properly measure performance, it is necessary to account for the cost of equity capital.
A variety of factors influence a firm's cost of capital. Some, such as the level of interest rates, state and federal tax policies, and the regulatory environment, are outside of the firm's control. However, the firm's financing and investment policies, especially the types of capital it uses and the types of investment projects it undertakes, have a profound effect on its cost of capital.
General Electric has long been recognized as one of the world's best-managed companies, and it has rewarded its shareholders with outstanding returns. Given its performance, it is not surprising that GE is always at or near the top of the list of companies in generating EVA. Thus, GE has been able to consistently find projects that earn more than their costs of capital.
Estimating the cost of capital for a company like GE is a fairly straightforward exercise, but it does require judgement. Since GE's capital comes largely from equity, its cost of capital depends to a large extent on the cost of its equity, which is in essence its shareholders' required return. One must recognize that when investors purchase GE stock, they are investing in a company that operates many different divisions throughout the world. Each of division has a different level of risk, hence a different cost of capital. GE's appliance division's cost of capital is likely to be different than that of its NBC subsidiary, or than that of its aircraft engine division. Likewise, an overseas project may have different risks and thus a different cost of capital than an otherwise similar domestic project.
As we will see in this chapter, estimating a project's cost of capital is an important process, and one that requires judgement. Companies that manage this process well will probably produce positive economic value for their shareholders.

DISCUSSION QUESTIONS

1. For highly profitable companies like Microsoft and Intel, does it make sense that they would have high or low costs of capital? Explain your answer.
2. If a firm fails to recognize that different divisions and projects can have different levels of risk and fails to properly risk-adjust the cost of capital, what effect do you think that might have on the firm's level of risk? The firm's cost of capital? The firm's value?

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