The high cost of confrontation.

• Author: Jacobs, Michael T.
• Position: Chairman's Agenda: Governing for Shareholder Prosperity

Thanks to distant relationships between shareowners and executives who run corporations, America has a cost-of-capital problem.

Any business person who has ever tried to justify a capital expenditure to senior management is familiar with the concept of the cost of capital. Typically, the most important criterion in determining which projects will make the next year's budget is their net present value or internal rate of return. Both measures are derived from discounted cash flow (DCF) models that are driven by a corporation's cost of capital. Companies regularly reject proposals that they believe would help their competitive strategy but that fail to show a return high enough to meet or exceed the company's cost of capital.

There is a growing belief in American business that we should disregard discounted cash flow techniques in managerial decision-making. Critics argue that important strategic decisions should not be based on these rigid financial formulas. But the problem is not with the analytical framework. If it is too hot outside, we cannot blame the thermometer. Our problem is that America's high cost of capital is giving us answers we do not like, because high capital cost systematically bias against investment with distant payoffs.

Understanding the economic factors that cause short-term behavior requires an analysis of the cost of capital and how it affects investment decisions and corporate strategies. The cost of capital is one of the most talked about but least understood competitiveness issues.

Like labor and raw materials, capital homes with a cost. But unlike expenditures for labor and raw materials, the cost of capital is difficult to measure and is never reported in a company's financial statements. Interest payments may be easy to monitor, but a company's cost of equity and overall cost of capital are enigmatic. Academics and business people define the cost of capital differently. Even within each community there is no consensus. In fact, virtually every study on the cost of capital uses a different method to try to quantify a company's capital costs.

What little has been written in the business press about the cost of capital is superficial and in some cases misleading. The solution to lower capital cost in America is commonly believed to be lower interest rates brought about by reducing the budget deficit and increasing personal savings. Others believe that lowering taxes is the solution to America's high capital costs...