Part 1 in a Series
Anyone who has studied business at the undergraduate level has learned a little about cost of capital. While this is not as prominent in most business owners’ minds as day-to-day operational issues, there is, perhaps, no matter more important for those owners to consider when making daily operational decisions.
Cost of capital is inextricably tied to the concept of value. Unfortunately, many business owners see financial planning related to their companies as one of taxable income minimization. This outcome is generally based on the way the Certified Public Accounting community has been trained to focus on year-to-year income and reducing that income, where possible, as a means of reducing income tax liabilities. This training then extends to the advice they provide their clients.
To be sure, tax minimization is a valid business goal but it is not in front of the concept of increasing value. For many people, the ownership interest of a privately-held business is the most significant asset in their portfolio of investments. However, few of those individuals realize the need to focus on value and growth in value related to day-to-day decision making.
An important step in creating value is to ensure that investments made on behalf of the business provide an economic return in excess of the economic cost of making that investment. Alternatively, if an investment made at the operational level provides an economic return lower than the economic cost of making that investment, value will be diminished. While these statements may seem painfully clear, it is striking how many businesses make investments which lead to value diminishment.
That is not to say that business investment in the short term should not produce a negative cash flow and possible value diminishment. Any initial business investment is likely to require upfront payments and produce a temporary cash outflow. In certain instances, these circumstances can lead to a temporary value change downward. However, it is critical that any proposed investment be evaluated over the complete life cycle of that investment so that all future cash inflows against cash outflows can be fully analyzed. In this way, it can easily be determined if the investment provides a positive return, verifying the capability of that investment to add value for the owner.
By way of example, assume a manufacturer of sheet metal products is considering the purchase and addition of a laser cutting machine with a price of $750,000. The volume specifications related to the machine clearly indicate that the business currently has insufficient customer workflow to operate the new machine at capacity. However, it is noted that the company’s sales force believes they can bring in new customers to fill the capacity of the machine in 36-48 months. Given these assumptions, it is clear that the Company will have significant dollars flowing out of the business (down payment, debt service, maintenance, etc.) before it is realizing cash inflows from full utilization of the new machine.
Factoring into the analysis, of course, will be tax incentives and the cash flows associated with certain tax advantages, as well as those cash flows associated with limited (and, hopefully, growing) production activity of with the machine.
The analysis simply requires that management evaluate the overall cost of the equipment acquisition over its entire life and compare that cost to the overall cash flows expected to be attained over that same period to evaluate the expected performance of the machine and to provide a full picture of whether the investment should be made.
Note, that the major element of cost is the cost associated with investing capital. Usually, this cost is a combination of equity capital and debt capital, but there can be an incredible variation from transaction to transaction. In most circles, the combination of these two types of capital is referenced as a weighted average cost of capital, or WACC. The WACC ultimately reflects the weighted cost of both elements of capital. The WACC associated with any contemplated business investment decision is the WACC applicable to the “next dollar financing,” meaning simply that the cost to be used in any specific investment should be that cost associated solely with that investment.
Once the specific project WACC is determined, the threshold required economic return is known as well. At that point, management has the target return identified for the project, thereby allowing for comparison of benefits against cost and a determination of the investment’s acquisition impact on value.
A series of discussions related to the finer points of this article will be posted in coming weeks to provide readers with a more detailed understanding of cost of capital and how to grow value. In the interim, should you have questions, or comments, please contact Bob Grossman at 412-338-9300.
View other posts in this series:
- Part 2: Equity Capital vs. Invested Capital
- Part 3: Construction of Discount Rates
