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A Losing Formula

Volatile financial markets can wreak havoc with your cost-of-capital calculations — and possibly skew your investment decisions and financial results.
Randy Myers, CFO Magazine
May 1, 2009

You could always say this about your company's cost-of-capital calculation: however complex it might be, you generally had to do it only once.

If only life were still so simple.

Thanks to volatile financial markets and a harsh economy, calculating a weighted average cost of capital that makes sense has become significantly more complex, and carries a far greater margin of error. At least one CFO has resorted to calculating two metrics, one for assessing short-term investment opportunities and another for vetting long-term projects.

Extraordinary times, it seems, demand extraordinary measurements — and hold the potential for extraordinary risks. Underestimate your capital cost and you might take on investments that are not, in fact, economically justifiable. Overestimate and you could wind up not taking on worthy projects.

You could tarnish today's financials, too. Setting your cost of capital too high will artificially boost the cost of your equity-compensation programs this year, and could inflate any impairment charges you must take on goodwill. A botched calculation also could affect the amount of incentive compensation awarded to any employees measured against your company's performance relative to its cost of capital.

The math behind all these calculations hasn't changed, of course, but the integrity of the inputs has. Treasury bond yields — a key component in reckoning the cost of equity, which is one part of a company's weighted average cost of capital — have fallen to historic and, some argue, unsustainable lows. That, warns Roger Grabowski, managing director at financial advisory and investment banking firm Duff & Phelps, could mask the business risks some companies face in this severely depressed economy. "At the very time you would expect that your risk, and therefore your cost of capital, should be higher," he says, "the beginning point of your cost-of-capital estimate is actually very low."

At the same time, Grabowski notes, stock prices have fallen dramatically, but not uniformly, with shares of financial firms and highly leveraged companies falling the hardest. Because stock volatility relative to the broader market is another component of the cost-of-capital calculation, any company whose stock was less volatile than the broader market might also come up with a misleadingly low calculation. Their risk may have declined relative to, say, bank stocks, Grabowski reasons, but not necessarily to the economy.

Of course, for companies that have seen their stocks brutalized and their access to affordable long-term debt choked off, this issue cuts in the other direction. They must worry whether their cost of capital is being artificially inflated. And layered over all of this is the question of whether any of these extreme cost-of-capital inputs are short-term aberrations that should be discounted.

An Impact on Goodwill
Phil Widman, senior vice president and CFO of Terex Corp., a $9.9 billion maker of construction, mining, and road-building equipment, says his company's cost of capital shot up about 20% last year, largely due to the impact of the increased volatility in the company's stock price. That hasn't been an issue in terms of making capital-allocation decisions, he says, since the company is in a cash-conservation mode and would only undertake investments with projected returns "way above" its capital costs anyway.

But he notes that such increases could boost the size of impairment charges at companies or could trigger further analysis related specifically to goodwill, potentially resulting in a write-down where one might not otherwise have been necessary. That's because a company's cost of capital figures into the rate at which it discounts cash flows to determine fair value. Last year, he speculates, most companies probably saw a 1 to 2 percentage point increase in the discount rates they use for that calculation.

Terex itself took a $459.9 million impairment charge for goodwill in the fourth quarter of last year, but that represented a write-down of the entire amount of goodwill in question, Widman notes. Accordingly, the discount rate in that case was a moot point.

At Caraustar Industries Inc., an $820 million paperboard producer, senior vice president and CFO Ron Domanico has addressed the cost-of-capital conundrum by abandoning, at least for now, the idea that any one number can cover every situation.

"In the past, we had one cost of capital that we applied to all our investment decisions," Domanico reports. "Today that's not the case. We have a short-term cost of capital we apply to short-term opportunities, and a longer-term cost of capital we apply to longer-term opportunities. And the reality is that the longer-term cost is so high that it has forced us to focus only on those projects that have immediate returns."

Domanico embraced this dual approach largely to account for the vast spread that has erupted between rates on short-term and long-term debt. Caraustar can borrow against its bank credit revolver at the lower of prime plus 4% or LIBOR plus 5% — a reasonable bogey for deciding, say, whether or not to take a 2% discount on a vendor invoice by paying early. But that's hardly a good benchmark for a $3 million equipment purchase. Hence, Domanico says, his separate, long-term cost-of-capital calculation takes into account the 12%-plus rates Caraustar would face today if it were to borrow long term.

One way CFOs can double-check the reasonableness of their cost-of-capital calculations, Grabowski says, is by comparing the number they get to a rough estimate based on the yield on the company's bonds (as opposed to Treasury yields) plus an average equity premium of, say, 4%, or perhaps more — maybe 7% for non-investment-grade companies.

"When you're done with your calculations, ask if the results make sense," he says. "During stable periods this may not be a difficult task, but at times like these, many companies may come up with nonsensical answers. Ask if your risk has changed. If it has, your cost of capital should be higher."

Randy Myers is a contributing editor of CFO.

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