Become a master of capital management.

• Author: Mitchell, Donald W.
• Position: Includes related articles on low investment rate of return accompanying low cost of capital

Lowering your cost of capital is a critical corporate strategy of the future. Here are the benefits of having a cost-of-capital advantage over your competitors.

Reducing cost of capital is the largest controllable source of costs that management can influence in the majority of companies today. However, few executives understand the critical strategic importance of accessing and using low-cost capital and actually making this a focus of their company's corporate strategy. Many executives focus their attention on providing capital for investments at low cost, but to outperform their competitors they need to understand why having a lower cost of capital, and more access to capital, can be one of a company's biggest competitive advantages. (See sidebar on page 43 for a comparison of the impact of cost-of capital reduction.)

A recent survey conducted by Mitchell and Company found that more than half of the highest-performing CEOs (in terms of growth in revenues, earnings, and stock price) were using a variety of management techniques, such as reengineering, TQM, reducing layers of management, and creating a more entrepreneurial environment. Almost all of these outstanding CEOs felt that it was critical that their companies have a cost-of-capital advantage over competitors. However, many felt they had no processes or programs in place to create that advantage.

Here are some of the reasons they cited for the importance of creating a cost-of-capital advantage, and why they should be arming their corporate strategy with what we are calling Theoretical Best Practice Capital Management.

1. Having a lower cost of capital means that their company can take over others and not be taken over.

   For a typical company with one-quarter of its capital in debt and the rest in equity, the average cost of capital will be lowered by the debt cost (around 4% to 5%) and raised by the equity cost (around 9% to 11%) to reach an average cost of capital of around 8% to 10%, using conventional measures of capital costs.

   Many people (especially investment bankers) then go on to conclude that adding a lot more debt is an attractive way to reduce the cost of capital. Others simply continue to use debt because they have always used this as the sole source of external financing, and have grown comfortable with debt because of this limited experience.

   Yet our outstanding CEOs disagreed with this approach because they typically use very little debt. They find that debt is risky, reduces their flexibility, and slows down their growth. Their first choice is to find ways to run their businesses that require less capital. When that route is exhausted, they then like to raise their stock-price multiple and sell equity to pay for rapid expansion or investment beyond what internal sources of cash can provide. They still have access to the debt markets if they need them, but have fewer strings attached in the meantime. (Such strings can include limiting covenants, negative publicity when debt ratings are downgraded, and costly interest charges.) By contrast, shareholders expect them to run the company the same way they have been, and intervening events like recessions do not put their strategic direction at risk like the fixed charges of debt do.

   Since such companies trade at a higher stock-price multiple because of their business performance, anyone who acquires them will have to be that much larger in order to be able to afford the transaction than the relative size of revenues, sales, and earnings would indicate. In addition, the acquirer will earn a lower return on the cash or stock it pays for the business, which will discourage most companies with a cost of capital of around 8% to 10%. These potential acquirers will not be able to earn a return above their own high cost of capital. For example, to acquire a company with a cost of capital of around 3% will often mean paying as much as 50 times current earnings. This will be true when this acquired company has no debt, trades at a stock-price multiple of 33 times current earnings, and the acquirer pays a 50% premium.

   (Some financial executives will want to know how any company could have a 3% cost of capital. Obviously, we are using equity measurements different from the disproven CAPM, which tends to give all companies about the same cost of capital. The astute financial executive will want to consider factors like the marginal dilution effect on key ratios that affect the stock price, the expected future of growth of the stock, types of financing instruments, and so forth. Such analysis will help clarify the fact that companies have quite differing costs of capital.)

   How can an 8% to 10% return on that investment be earned next year? It obviously cannot, and it would be difficult to earn much more than 2% in the near term. Without extraordinary future growth, the purchase price is just too expensive. Actually, most companies will want to earn a...