UK: MATTERS OF RISK AND RETURN. - Which figures should go into calculating the cost of capita?

Last Updated: 31 Aug 2010

Which figures should go into calculating the cost of capita?

Before deciding which way to go in order to get where you want, it's useful to know where you are. Similarly, to make a reasonable assessment of any capital investment proposal, you should first know your cost of capital. This will give an idea, not only of how the investment will be paid back, but also of the opportunity cost involved. Calculating the cost of capital should in theory be fairly straightforward, based on a weighted average of debt and equity cost (depending on how the venture is to be funded) and building in risk factors as appropriate. In the real world, deciding which figures should go into the calculation is by no means so clear-cut.

In the US, it appears, there is a fairly broad consensus that the 'capital-asset pricing model' (a formula for calculating the cost of equity finance based on return and risk) is the best way to arrive at the true cost of equity. However, academics at the universities of Washington and Virginia (the September-October 1996 issue of Harvard Business Review records) found significant variation in how elements of the formula are calculated. For example, there are different sources from which to obtain a risk factor for the stock market as a whole; marginal or average tax rates may be used to arrive at returns; and so on.

Nevertheless, the CAPM approach is almost as widely accepted in the UK as in the US, according to Dr Anne Fremault Vila of the London School of Economics. 'Most but not all financial institutions use this model these days. It's seen as very practical,' she says. 'I am always surprised when people don't use it to calculate not only return but risk.' 'In practice a large number of different approaches are used,' according to an analyst in the treasury department of one high street institution. 'CAPM is easy to calculate but it gives rise to the question of what it means. I'm extremely suspicious of neatly packaged answers.'

The 'true' cost of capital is at present a particularly contentious issue for privatised utilities, since it is used to determine a 'fair' rate of return. The Monopolies and Mergers Commission report on British Gas suggested a range for the company's cost of capital between 6.5% and 7.5%.

Since the average annual return on quoted equities has been more like 15% over the past 30 years, the utilities feel hard done by. Professor Dean Paxson of Manchester Business School is studying to what extent the risk posed by regulatory decisions has been left out of the calculation. 'A 7% real cost of capital is used in practice, but there's little agreement except that the assumption of a constant cost of capital isn't acceptable.'

In the case of the riskiest investments a textbook approach is of little use, maintains Hugh Richards, a director of 3i - Britain's biggest provider of capital for buy-outs, buy-ins and start-ups. 'Providing capital to unquoted companies is an extremely inexact science. CAPM and similar models are applicable to large, publicly quoted companies whose status is not likely to change quickly for better or worse' - but not for lesser, more volatile, businesses. And Richards warns, 'When you have spreadsheet jockeys relying on formulae, there's a danger that that sort of thinking can lead to poor investment judgment.'

Nevertheless it's doubtful whether, at the bigger end of British business, finance directors are any more clear headed and consistent than the Americans in their cost of capital calculations.

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