Do You Know Your Cost of Capitals
HBR.ORG
Do You Know
Your Cost of
Capital?
Probably not, if your company is like most by Michael T. Jacobs and Anil Shivdasani
July–AuGust 2012 reprinT r1207L
For arTicLe reprinTs caLL 800-988-0886 or 617-783-7500, or visiT hbr.org
Do You
Know
Your Cost
Of Capital? probably not, if your company is like most by Michael T.
Jacobs and Anil Shivdasani
W
With trillions of dollars in cash sitting on their balance sheets, corporations have never had so much money. How executives choose to invest that massive amount of capital will drive corporate strategies and determine their companies’ competitiveness for the next decade and beyond. And in the short term, today’s capital budgeting decisions will influence the developed world’s chronic unemployment situation and tepid economic recovery.
Although investment opportunities vary dramatically across companies and industries, one would expect the process of evaluating financial returns on investments to be fairly uniform. After all, business schools teach more or less the same evaluation techniques. It’s no surprise, then, that in a survey con-
CopyRigHt © 2012 HaRvaRd Business sCHool puBlisHing CoRpoRation. all RigHts ReseRved.
July–August 2012 Harvard Business Review 3
Do You KnoW Your Cost of CAPitAl?
ducted by the Association for Financial Professionals (AFP), 80% of more than 300 respondents—and
90% of those with over $1 billion in revenues—use discounted cash-flow analyses. Such analyses rely on free-cash-flow projections to estimate the value of an investment to a firm, discounted by the cost of capital (defined as the weighted average of the costs of debt and equity). To estimate their cost of equity, about 90% of the respondents use the capital asset pricing model (CAPM), which quantifies the return required by an investment on the basis of the associated risk.
But that is where the consensus ends. The AFP asked its global membership, comprising about
Do You Know
Your Cost of
Capital?
Probably not, if your company is like most by Michael T. Jacobs and Anil Shivdasani
July–AuGust 2012 reprinT r1207L
For arTicLe reprinTs caLL 800-988-0886 or 617-783-7500, or visiT hbr.org
Do You
Know
Your Cost
Of Capital? probably not, if your company is like most by Michael T.
Jacobs and Anil Shivdasani
W
With trillions of dollars in cash sitting on their balance sheets, corporations have never had so much money. How executives choose to invest that massive amount of capital will drive corporate strategies and determine their companies’ competitiveness for the next decade and beyond. And in the short term, today’s capital budgeting decisions will influence the developed world’s chronic unemployment situation and tepid economic recovery.
Although investment opportunities vary dramatically across companies and industries, one would expect the process of evaluating financial returns on investments to be fairly uniform. After all, business schools teach more or less the same evaluation techniques. It’s no surprise, then, that in a survey con-
CopyRigHt © 2012 HaRvaRd Business sCHool puBlisHing CoRpoRation. all RigHts ReseRved.
July–August 2012 Harvard Business Review 3
Do You KnoW Your Cost of CAPitAl?
ducted by the Association for Financial Professionals (AFP), 80% of more than 300 respondents—and
90% of those with over $1 billion in revenues—use discounted cash-flow analyses. Such analyses rely on free-cash-flow projections to estimate the value of an investment to a firm, discounted by the cost of capital (defined as the weighted average of the costs of debt and equity). To estimate their cost of equity, about 90% of the respondents use the capital asset pricing model (CAPM), which quantifies the return required by an investment on the basis of the associated risk.
But that is where the consensus ends. The AFP asked its global membership, comprising about