The cost of capital is a ubiquitous metric for corporate executives, showing up in almost every aspect of their job description. It drives investing decisions, helps determine financing choices, and affects dividend policy and valuations. That being said, cost of capital is often mangled and misused in practice, and it seems that rather than operating within a range that minimize the cost of capital corporate executives make financing choices based upon perceptions of the cheapness (or costliness) of capital. For example, aside from refinancing more costly debt, companies were using the money raised to pay dividends to shareholders, buy other businesses, and repurchase their own stocks, you name it. As a result of this, many companies ended up with unsustainable debt-to-capital ratio levels.
Essentially, I have two questions when investing in any business. First and foremost, where is the company in the capital structure? It is true that some managers and investors like me, in the name of prudence, think that less debt is always better than more debt, and no debt is optimal. And second, what do we think about the company’s excess return on invested capital? Scaling profits to invested capital yields accounting returns, and comparing those returns to costs of funding, we get excess returns, shorthand for the value created or destroyed by growth. If last year was a reminder to investors that the end game for every business is to not just generate profits, but to generate enough profits to cover its opportunity costs, i.e, the returns they can make on investments of equivalent risk, and that game became a lot more difficult to win in 2022. A combination of rising risk free rates and surging risk premiums (equity risk premiums and default spreads) has conspired to push the cost of capital of both US and global companies more than any year in history.
In the repository https://github.com/rnfermincota/academic/tree/main/research/traditional_assets/database, I share the database of excess returns to equity and the firm for ~44,500 publicly traded companies across sectors and regions. Starting with how the market is pricing risk (both country and equity risk premiums), and then moving on to the cost of equity at each debt ratio, and then estimated the interest coverage ratio, synthetic rating, and cost of debt, taking care to ensure that if the interest expenses exceed the operating income, tax benefits would be lost. These hurdle rates also represent benchmarks that businesses have to beat to create value. When we invest capital in risky businesses, we need to not just make money, but make enough to cover what we could have earned on investments of equivalent risk. In fact, comparing the accounting returns to the costs of equity and capital allow us to compute excess returns to equity and the firm. It is certainly true that while the typical company had trouble making its costs of equity or capital, there are industry groups that generate returns that significantly exceed their costs, just as there are industry groups that operate as drags on the market. Put simply, value creation comes from delivering returns on equity and capital that are higher than the costs of equity and capital, and while we can take issue with using accounting returns from the most twelve months as a proxy for long term returns, the comparison is still a useful one to make.
For the past decade I have extended my lectures far beyond what is labeled as corporate finance, introducing students to some numerical methods to show how calculus (https://github.com/rnfermincota/academic/blob/main/research/traditional_assets/database/effective-cost-debt.pdf) can be used to get a sense of how much debt a business can safely carry. In class students also learn how to use data from trusted data vendors including S&P Capital IQ, Bloomberg, and a host of specialized data sources used to estimate the optimal capital structure for publicly traded companies, listed globally, and what each company can sustain in debt as we change the current debt to capital ratio to a target debt ratio. The target debt ratio is estimated by calculating the mix of debt and equity that minimizes the weighted average cost of capital of a company while maximizing its market value. My experience is that students find the optimal capital structure approach difficult at the outset and struggle to get their arms around the formulations at different debt ratios. The complications with estimating the optimal financing mix (debt-to-capital ratio level that yield the lowest cost of capital) across companies lie in two aspects. First, in the statistical problems with estimating risk parameters (https://rpubs.com/rafael_nicolas/crp), and second, with the financial models built on these parameters (https://rpubs.com/rafael_nicolas/sp500_monthly_valuation). There is a way of estimating costs of capital that is agnostic about the choice of models, but it leads to circular reasoning, at least in the context of valuation. Here, the cost of capital operates as an optimizing tool for capital structure, where the price of risk is set by markets, and it enters the cost of capital in two places. When estimating the cost of equity, it manifests as an equity risk premium, and when estimating cost of debt, it shows up as a default spread. Both metrics are set by markets, reflect investor risk aversion and change over time, and this is a reductive approach in the sense that it reduces the complexity of valuation modeling.
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