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Message
Should companies even think about Cost of Capital when evaluating new projects?
Posted on 5/12/13 at 3:34 pm
Posted on 5/12/13 at 3:34 pm
Evaluate this news release a company proposes to issue to analysts:
"For years we have thought about our business strategy, without worrying about financing. Times have changed and we need to think about our cost of capital. Since (a) debt is always cheaper than equity; (b) we have decided to use debt to finance our next major projects."
What is your assessment of this statement?
A) The statement is false.
B) The statement is partly true/false.
C) The statement is true
Thoughts:
For years we have thought about our business strategy, without worrying about financing.
OK, I'll take that as good. Taking projects or not should be an NPV or IRR related question. Financing adds no value! Therefore, decisions about taking/rejecting projects should not worry about financing.
Times have changed and we need to think about our cost of capital.
OK, I can see where CoC is important, especially if one wants to look at NPVs of projects. So changing your methods to include CoC=r is a good thing, better than just tossing money into a project because one thinks it is a good project. So this could be good. However, if the company means Financing (or cost of financing/debt) when they says "cost of capital" then it is wrong!
Since (a) debt is always cheaper than equity;
eh, here I am torn. I guess debt generally is cheaper because of the tax advantages. But then again, there is that "always" and that makes this an absolute statement.
we have decided to use debt to finance our next major projects."
OK, you decided to use debt. Non-controversial statement of fact. However, as a conclusion to "debt is always cheaper" I say - huh? What basis? What analysis?
With so many questions about parts, how can we select an "absolute" (T/F) Answer?
"For years we have thought about our business strategy, without worrying about financing. Times have changed and we need to think about our cost of capital. Since (a) debt is always cheaper than equity; (b) we have decided to use debt to finance our next major projects."
What is your assessment of this statement?
A) The statement is false.
B) The statement is partly true/false.
C) The statement is true
Thoughts:
For years we have thought about our business strategy, without worrying about financing.
OK, I'll take that as good. Taking projects or not should be an NPV or IRR related question. Financing adds no value! Therefore, decisions about taking/rejecting projects should not worry about financing.
Times have changed and we need to think about our cost of capital.
OK, I can see where CoC is important, especially if one wants to look at NPVs of projects. So changing your methods to include CoC=r is a good thing, better than just tossing money into a project because one thinks it is a good project. So this could be good. However, if the company means Financing (or cost of financing/debt) when they says "cost of capital" then it is wrong!
Since (a) debt is always cheaper than equity;
eh, here I am torn. I guess debt generally is cheaper because of the tax advantages. But then again, there is that "always" and that makes this an absolute statement.
we have decided to use debt to finance our next major projects."
OK, you decided to use debt. Non-controversial statement of fact. However, as a conclusion to "debt is always cheaper" I say - huh? What basis? What analysis?
With so many questions about parts, how can we select an "absolute" (T/F) Answer?
This post was edited on 5/12/13 at 3:41 pm
7
Posted on 5/12/13 at 4:05 pm to rickgrimes
This is more of a balance sheet and strategy question than a discounted cash flow question. If this is an actual press release, turn and run from this ignorant company. I take it this is a class question, though.
Debt financing requires more careful cash flow planning, since payments on loans and notes are due, or else. Equity financing gives you much more flexibility to take risk for deferred rewards, since once the common stock has been issued dividend payments are optional and "cost of capital" is relative to these investors' expectations and not a hard and fast commitment. Now expect stock price to fluctuate if you are not delivering on current cash flow and growth potential.
"Debt is always cheaper than equity" sounds like trolling. if you plan on loading up on debt and tanking your credit rating, what do you expect to see as your marginal cost of borrowing? An equity position or joint venture may be a more effective means of financing at that point.
So my overall assessment of this statement is to fire whoever came up with it. However, I am not a finance guy, so take all of my comments with a grain of salt.
Debt financing requires more careful cash flow planning, since payments on loans and notes are due, or else. Equity financing gives you much more flexibility to take risk for deferred rewards, since once the common stock has been issued dividend payments are optional and "cost of capital" is relative to these investors' expectations and not a hard and fast commitment. Now expect stock price to fluctuate if you are not delivering on current cash flow and growth potential.
"Debt is always cheaper than equity" sounds like trolling. if you plan on loading up on debt and tanking your credit rating, what do you expect to see as your marginal cost of borrowing? An equity position or joint venture may be a more effective means of financing at that point.
So my overall assessment of this statement is to fire whoever came up with it. However, I am not a finance guy, so take all of my comments with a grain of salt.
Posted on 5/12/13 at 4:52 pm to rickgrimes
The statement just sounds odd. Why not something like the following?
"In recent years our business has been so successful that we have been able to fund new opportunities directly out of the company's cash flow. This continuing success has led to an even larger set of growth opportunities. With the company's strong balance sheet and cash flow, combined with the low cost of debt financing in today's market, we plan to issue corporate bonds to fund this additional growth."
"In recent years our business has been so successful that we have been able to fund new opportunities directly out of the company's cash flow. This continuing success has led to an even larger set of growth opportunities. With the company's strong balance sheet and cash flow, combined with the low cost of debt financing in today's market, we plan to issue corporate bonds to fund this additional growth."
This post was edited on 5/12/13 at 4:53 pm
Posted on 5/12/13 at 11:23 pm to rickgrimes
Cost of capital is in the NPV equation, so it is a big factor in whether a project has a positive or negative NPV. I think a company should always be thinking about their cost of capital.
Ideally, debt would be best to finance a project because it is cheaper than equity. You need to make certain that you will have adequate cash flows to cover the interest payments though. If there are questions about whether a company can make the interest payments, then financing with equity is probably a better idea. Also, debt covenants can be a bitch.
Ideally, debt would be best to finance a project because it is cheaper than equity. You need to make certain that you will have adequate cash flows to cover the interest payments though. If there are questions about whether a company can make the interest payments, then financing with equity is probably a better idea. Also, debt covenants can be a bitch.
Posted on 5/13/13 at 10:07 am to rickgrimes
The line of thinking is entirely wrong. The cost of capital of an organization should not have anything to do with an investment decision of a project.
The risk of the project should determine the cost of capital or riskiness upon which the investment should be evaluated.
The risk of the project should determine the cost of capital or riskiness upon which the investment should be evaluated.
Posted on 5/13/13 at 10:23 am to rickgrimes
Thanks guys for your inputs. Your comments reinforced what I believed also. The bottom line is that it is a poorly constructed statement.
Posted on 5/13/13 at 3:33 pm to Duck
quote:
The line of thinking is entirely wrong. The cost of capital of an organization should not have anything to do with an investment decision of a project.
It certainly should. Your investors will be better off if you return their money than if you invest in a negative-NPV project. Your investors will not be too thrilled if you're putting their money into projects that don't properly compensate them for the risk they're undertaking.
quote:
The risk of the project should determine the cost of capital or riskiness upon which the investment should be evaluated.
The risk should be determined by the expected cash flow, which consists of running a sensitivity analysis to assign probabilities to cash flows under different scenarios. Using these expected cash flows, you then find the IRR. If the IRR is higher than your cost of capital, then there is really no reason why you shouldn't invest in the project.
Posted on 5/13/13 at 3:43 pm to rickgrimes
You should send out a personal request for Rex to answer your questions. He is a retired CFO, so he should have personal experience in making similar decisions.
Posted on 5/13/13 at 3:45 pm to Poodlebrain
quote:
You should send out a personal request for Rex
I wouldn't communicate with Rex unless I absolutely had to
Posted on 5/13/13 at 4:54 pm to OFWHAP
quote:
The risk should be determined by the expected cash flow, which consists of running a sensitivity analysis to assign probabilities to cash flows under different scenarios. Using these expected cash flows, you then find the IRR. If the IRR is higher than your cost of capital, then there is really no reason why you shouldn't invest in the project.
I don't think you know exactly what you are talking about. Their is a cost of capital for an organization. This cost of capital is a factor of three things 1) cost of equity 2) cost of debt 3) company's d/e ratio. Using this cost of capital to evaluate investment decisions is incorrect.
The problem arises in large diversified organization. For instance, if I am a consumer products company with a Cost of Equity of 10%, Cost of Debt of 5% & 50/50 D/E, I can't use my resulting 7.5% cost of capital to evaluate an offshore oil project in Mozambique.
The risk or discount rate that should be used to evaluate such project should be calculated based on pure play information in the market. Including cost of equity of comps, cost of debt, and d/e ratio.
The problem with what you are saying is that it doesn't take into effect the changing asset picture of an organization. Cost of capital is inherently backward looking and you are trying to make a forward looking decision. This works fine as long as the project has very similar characteristics as your past line of business; however, if you are changing the nature of the business, the cost of equity also must change which changes the whole discount rate. This change occurs because equity investors are going to require additional return for the risk that you are adding to company.
This post was edited on 5/13/13 at 5:24 pm
Posted on 5/13/13 at 7:47 pm to Duck
quote:
The problem arises in large diversified organization. For instance, if I am a consumer products company with a Cost of Equity of 10%, Cost of Debt of 5% & 50/50 D/E, I can't use my resulting 7.5% cost of capital to evaluate an offshore oil project in Mozambique.
If the capital markets give you a 7.5% WACC, then why shouldn't you use that cheap financing to your advantage?
If you're invested in this consumer products firm, which then decides to diversify into E&P, then you're well within your rights to sell your stock if you believe it's overvalued. In fact the likely reason that management is making such a bold move is that they also believe that their company's stock is overvalued and want to take advantage of cheap financing.
Posted on 5/13/13 at 7:57 pm to Bayou Tiger
quote:
"Debt is always cheaper than equity" sounds like trolling. if you plan on loading up on debt and tanking your credit rating, what do you expect to see as your marginal cost of borrowing? An equity position or joint venture may be a more effective means of financing at that point.
Debt is ALWAYS cheaper than equity because owning debt is less risky than owning equity. In the event of bankruptcy, debt holders take over the company while equity holders are wiped out.
Now in your case of loading up on debt and tanking your credit rating, debt will still be cheaper than equity, as each marginal dollar you borrow adds even more risk for equity investors.
Posted on 5/13/13 at 11:00 pm to rickgrimes
Modigliani and Miller says it does not matter.LOL.
This post was edited on 5/13/13 at 11:04 pm
Posted on 5/14/13 at 12:28 am to Duck
quote:
I don't think you know exactly what you are talking about. Their is a cost of capital for an organization. This cost of capital is a factor of three things 1) cost of equity 2) cost of debt 3) company's d/e ratio. Using this cost of capital to evaluate investment decisions is incorrect.
The problem arises in large diversified organization. For instance, if I am a consumer products company with a Cost of Equity of 10%, Cost of Debt of 5% & 50/50 D/E, I can't use my resulting 7.5% cost of capital to evaluate an offshore oil project in Mozambique.
The risk or discount rate that should be used to evaluate such project should be calculated based on pure play information in the market. Including cost of equity of comps, cost of debt, and d/e ratio.
The problem with what you are saying is that it doesn't take into effect the changing asset picture of an organization. Cost of capital is inherently backward looking and you are trying to make a forward looking decision. This works fine as long as the project has very similar characteristics as your past line of business; however, if you are changing the nature of the business, the cost of equity also must change which changes the whole discount rate. This change occurs because equity investors are going to require additional return for the risk that you are adding to company.
I agree with everything in this post.
Here is how I understand CoC and Modigliani-Miller theory:
Let's say there are two very similar companies, Apple and Orange. Assume Apple has no debt and Orange has some debt. In an ideal world, if Apple and Orange since are similar companies, their return on assets will be the same regardless of how they are financed.
Since their return on reals assets are the same, and one company has debt and other doesn't, their return on equity has to be different.
The expected rate fo return on equity of a levered firm increases in proportion to the debt/equity ratio as expressed by this WACC equation:
r(equity) = r(assets)+D/L[r(assets)-r(debt)]
If debt is zero, return on equity = return on assets. If you are going into a new business and a similar company already exists, the return on equity of that competitor along with debt info will help you estimate the discount rate (or return on assets) for your new business.
Posted on 5/14/13 at 1:23 am to OFWHAP
quote:
Debt is ALWAYS cheaper than equity because owning debt is less risky than owning equity. In the event of bankruptcy, debt holders take over the company while equity holders are wiped out.
Your debt just became equity. The cost curve has a parabolic shape. Posted on 5/14/13 at 9:25 am to OFWHAP
quote:
If the capital markets give you a 7.5% WACC, then why shouldn't you use that cheap financing to your advantage?
This is impossible. Based on your statement any company with a low cost of capital would invest in anything with a higher return than their CoC and eventually own everything.
Posted on 5/14/13 at 9:25 am to rickgrimes
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