VideoQuick, what's your company's cost of capital? Not sure? That's OK — you're far from alone. Finance executives have long wrestled with that question when establishing hurdle rates for investments. During the last throes of the bull market, with capital dirt-cheap, it didn't much matter. But the bear market has made capital dear once again, and brought the question of its exact cost back to center stage.
Calculating the price of debt is not the problem: subtract the prevailing interest rate on Treasury bonds from the rate on a company's equivalently timed debt, and the resulting spread will serve as a perfectly reliable measure of investors' expectations that the company will default on those obligations. That spread can then be used to establish the returns an investment must produce to satisfy bondholders that the risk of default is worth taking.
The rub comes in trying to reckon the cost of a company's equity. There is simply no way — yet — of definitively measuring the risk that a company won't be able to satisfy shareholders as well as bondholders, who after all have first dibs on a company's assets in the event of bankruptcy. In the absence of a better alternative, for nearly 40 years many academics and finance executives have accepted the capital asset pricing model (CAPM), or some variation of it, as an adequate means of approximating the cost of equity.
Recently, however, proponents of a new methodology have claimed that companies can use options-pricing theory to estimate their cost of equity, and therefore capital, to a far greater degree of accuracy than ever before. Is it time to throw away the old yardstick?
Beta Blockers
Introduced in 1963 by Stanford University professor William Sharpe, and building on the pioneering portfolio-optimization theory of Harry Markowitz, CAPM was designed to help investors develop a diversified portfolio of assets. (Both Sharpe and Markowitz won Nobel prizes for their work.) But CAPM also found its way into corporate offices as a standard formula for establishing minimum acceptable returns for capital allocation of all kinds, including acquisitions, product development, and restructuring projects.
The trouble is, CAPM isn't particularly well suited for corporate purposes, as both theorists and practitioners have come to acknowledge. "A square peg in a round hole" is how Tony D. Yeh, a principal in the San Francisco-based consulting firm Pacifica Strategic Advisors LLC, describes CAPM's application to hurdle rates. He's not alone. "I don't think there's any question that CAPM is not appropriate" to calculate hurdle rates, declares Robert Reilly, managing director of Chicago — based consulting firm Willamette Management Associates.
What's wrong with CAPM? Yeh, Reilly, and others say the model's basic flaw is the way it calculates the equity risk premium — the amount of return that equity investors require above and beyond the rate available on bonds.
In calculating this premium, CAPM relies on a measure known as beta, which multiplies the volatility of an asset's price by its correlation, or the degree to which the price moves in line with prices of other assets. The result works well when the goal is to select assets that serve to diversify a portfolio. After all, an asset's price may be hugely volatile but pose little risk for a diversified portfolio if it is totally uncorrelated to prices of other assets. (Indeed, a volatile asset will actually decrease a portfolio's overall risk if other assets' price movements are in exactly the opposite direction.)
But because of the way CAPM takes correlation into account, it fails to measure the overall risk of the asset — and by extension, the value of an investment in it. That, experts say, is a significant drawback for corporate managers, who are paid to ensure that a company's assets do better than match average returns. While it might once have made sense to consider each of a company's investments in terms of how it fit into a diverse portfolio, the current consensus is that managers should focus on investments that capitalize on a core business competency.
Sharpe himself disputes the notion that CAPM isn't suitable for setting hurdle rates. He says managers who focus on company-specific risk are likely to set hurdle rates too high, depriving investors of opportunities they would prefer that the company exploit.
Up Close and Flawed
Yet CAPM clearly produces some odd results. Look, for instance, at Atlanta — based home-improvement retailer Home Depot, which sported a beta of 1.6 in 1995. That figure suggested that the company's stock was more than half again as risky as the overall market and more than twice as risky as, for instance, Wolohan Lumber Co., a small competitor based in Saginaw, Michigan, whose beta was only 0.75 at the time.
Considering risk strictly on the basis of beta, however, would have missed the fact that Home Depot's profit margins were steadily rising while Wolohan's were shrinking. Three years later, in fact, both companies had a beta of 0.70. Whatever its virtues as a historical measure of risk, beta, as this and other examples demonstrate, has no particular predictive value.
As a result of beta's unreliability, many companies simply ignore CAPM, choosing an arbitrary hurdle rate based on a gut-level sense of what all of a company's various investments should earn. A former finance executive at Boston — based Gillette Co. says that until recently the shaving-products company adhered to a hurdle rate of 20 percent, no matter what type of project was under consideration.
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