Having gone to the effort of calculating a company’s weighted cost of capital we discussed on my previous post, we must ask ourselves if this information is of any use. Certainly, we now know the cost of all corporate funding, but this is the cost of funding that has already been incurred. How does this relate to the cost of capital for any upcoming funding that has not yet been obtained? What if a company wants to change its blend of funding sources, and how will this impact the cost of capital? What about using it to discount the cash flows from existing projects? The weighted cost of of capital simply does not answer all those questions. We are going to discuss the incremental cost of capital in this post. Enjoy!
The trouble with the existing weighted cost of capital is that it reflects the cost of debt and equity only at the time the company obtained it. For example: if a company obtained debt at a fixed interest rate during a period in the past when the prime rate offered by banks for new debt was very high, the resulting cost of capital, that still includes this debt, will be higher than the cost of capital if that debt had been retired and refunded by new debt that was obtained at current market rates, which are lower.
The same issue applies to equity, because the cost of equity can change if the underlyingreturn on risk-free debt has changed, which it does continually (just observe daily or monthly swings in the cost of U.S. government securities, which are considered to be risk free). Similarly, a company’s beta will change over time as its overall risk profile changes, possibly due to changes in its markets, or internal changes that alter its mix of business. Accordingly, a company may find that its carefully calculated weighted cost of capital does not bear even a slight resemblance to what the same cost would be if recalculated based on current market conditions. Where does this disturbing news leave us?
If there is no point in using the weighted cost of capital that is recorded on the books, there is no reason why we cannot calculate the incremental weighted cost of capital based on current market conditions and use that as a hurdle rate instead. By doing so, a company recognizes that it will obtain funds at the current market rates, and use the cost of this blended rate to pay for new projects. For example: if a company intends to retain the same proportions of debt and equity, and finds that the new weighted cost of capital is 2 percent higher at current market rates than the old rates recorded on the company books, then the hurdle rate used for evaluating new projects should use the new, higher rate.
It is also important to determine management’s intentions in regard to the new blend of debt and equity, for changes in the proportions of the two will alter the weighted cost of capital. If a significant alteration in the current mix is anticipated, the new proportion should be factored into the weighted cost of capital calculation. For example: management may be forced by creditor or owners to alter the existing proportion of debt and equity. This is most common when a company is closely held, and the owners do not want to invest any more equity in the company, thereby forcing it to resort to debt financing. Alternatively, if the debt-to-equity ratio is very high, lenders may force the addition of additional equity in order to reduce the risk of default, which goes up when there is a large amount of interest and principal to pay out of current cash flow. In short, the incremental cost of capital is the most relevant hurdle rate figure when using new funds to pay for new projects. The concept of incremental funds costs can be taken too far, however.
If a company is initiating only one project in the upcoming year and needs to borrow funds at a specific rate to pay for it, then a good case can be made for designating the cost of that funding as the hurdle rate for the single project under consideration, since the two are inextricably intertwined. However, such a direct relationship is rarely the case. Instead, there are many projects being implemented, which are spread out over a long time frame, with funds being acquired at intervals that do not necessarily match those of the funds requirements of individual projects. For example: a chief financial officer may hold off on an equity offering in the public markets until there is a significant upswing in the stock market, or borrow funds a few months early if a favorably low, long-term fixed rate can be obtained. When this happens, there is no way to tie a specific funding cost to a specific project, so it is better to calculate the blended cost of capital for the period and apply it as a hurdle rate to all of the projects currently under consideration.
All this discussion of the incremental cost of capital does not mean that the cost of capital that is derived from the book cost of existing funding is totally irrelevant—far from it. Many companies finance all new projects out of their existing cash flow and have no reason to go to outside lenders or equity markets to obtain new funding. For these organizations, the true cost of debt is indeed the same as the amount recorded on their books, because they are obligated to pay that exact amount of debt, irrespective of what current market interest rates may be. However, the weighted cost of capital does not just include debt—it also includes equity, and this cost does change over time. Even if a company has no need for additional equity, the cost of its existing equity will change, because the earnings expectations of investors will change over time, as well as the company’s beta. For example, the underlying risk-free interest rate can and will change as the inflation rate varies, so that there is some return to investors that exceeds the rate of inflation.
Similarly, the average market rate of return on equity will change over time as investor expectations change. Further, the mix of businesses and markets in which a company is involved will inevitably lead to variation in its beta over time, as the variability of its cash flows becomes greater or lower. All three of these factors will result in alterations to the weighted cost of capital that will continue to change over time, even if there is no new equity that a company sells to investors. Consequently, the book cost of debt is still a valid part of the weighted cost of capital as long as no new debt is added, whereas the cost of equity will change as the expectation for higher or lower returns by investors changes, which results in a weighted cost of capital that can blend the book and market costs of funding in some situations.
So far, the discussion in this post has assumed that the reader is interested only in using the weighted cost of capital as a hurdle rate for determining the viability of new projects that will generate a stream of cash flows. It can also be used as the discounting factor when arriving at the net present value of cash flows from existing projects. When this is the case, the cost of capital based on the book value of debt is more appropriate than using the current market rates for new debt, since the cash flows being discounted are for existing projects that were already funded by debt and equity that are already recorded on the books.
This section noted how the incremental market cost of capital is the more accurate way to arrive at a hurdle rate for new projects when new funding must be secured to pay for the projects. If a company can fund all cash flows for new projects internally, however, a company can use the book cost of debt and the market-based return on equity to derive the weighted cost of capital that is most accurately used to judge the acceptability of cash flows from prospective new projects. This later version is also most appropriate for discounting the cash flows from existing and previously funded projects.