Does the Exact Cost of Capital Really Matter?
Feb 12, 2014
As a financial executive and a consultant, I’ve been a part of or observed endless debates about what is the correct cost of capital to use in evaluating a project’s net present value (NPV). And I have to ask: Does this debate really matter?
Don’t get me wrong – I’m a big believer in the Capital Asset Pricing Model (CAPM). No, my question is whether it really matters what the exact cost of capital should be. That debate is one that only finance purists love to have.
[If you’re not familiar with these terms, the NPV calculation evaluates cash flows that occur over long periods of time, typically 3 years or more, and is central to CAPM. The objective is to make decisions about whether to go forward with large, capital-intensive projects, or which of several projects to choose from. Cost of capital is a sort of interest rate used in the calculation, making cash inflows (or outflows) occurring far in the future less significant than nearer-term inflows (or outflows). For this reason, cost of capital is sometimes called the “discount rate,” because it discounts future cash flows.]
I’m skeptical because often, the NPV analysis’s recommended decision simply isn’t sensitive to the exact value of the cost of capital, at least not within a range of 2%-3%, and sometimes an even wider range. And even when it’s somewhat sensitive, there’s a good chance the ultimate decision will be driven by subjective, possible non-financial factors that need to be considered.
Most of the time, your time is better spent understanding the detailed business implications of your decision than analyzing the exactly correct cost of capital for your organization. If a sensitivity analysis shows that the exact cost of capital matters to the analysis, and the dollars involved are large enough, then and only then is it worth it to fine-tune your cost of capital.
All too often in quantation, we waste valuable time – and confuse our audience – with exquisite analysis of factors that just don’t make much difference in the long run.
“Painting with Numbers” is my effort to get people talking about financial statements and other numbers in ways that we can all understand. I welcome your interest and your feedback.
Don’t get me wrong – I’m a big believer in the Capital Asset Pricing Model (CAPM). No, my question is whether it really matters what the exact cost of capital should be. That debate is one that only finance purists love to have.
[If you’re not familiar with these terms, the NPV calculation evaluates cash flows that occur over long periods of time, typically 3 years or more, and is central to CAPM. The objective is to make decisions about whether to go forward with large, capital-intensive projects, or which of several projects to choose from. Cost of capital is a sort of interest rate used in the calculation, making cash inflows (or outflows) occurring far in the future less significant than nearer-term inflows (or outflows). For this reason, cost of capital is sometimes called the “discount rate,” because it discounts future cash flows.]
I’m skeptical because often, the NPV analysis’s recommended decision simply isn’t sensitive to the exact value of the cost of capital, at least not within a range of 2%-3%, and sometimes an even wider range. And even when it’s somewhat sensitive, there’s a good chance the ultimate decision will be driven by subjective, possible non-financial factors that need to be considered.
Most of the time, your time is better spent understanding the detailed business implications of your decision than analyzing the exactly correct cost of capital for your organization. If a sensitivity analysis shows that the exact cost of capital matters to the analysis, and the dollars involved are large enough, then and only then is it worth it to fine-tune your cost of capital.
All too often in quantation, we waste valuable time – and confuse our audience – with exquisite analysis of factors that just don’t make much difference in the long run.
“Painting with Numbers” is my effort to get people talking about financial statements and other numbers in ways that we can all understand. I welcome your interest and your feedback.
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