Costs of capital: that’s Wacc
Corporate cash will grow, but how this is deployed will be key
For many companies, it is a rite of January to re-visit corporate cost of capital. Dramatic changes in the US tax regime, an unstoppable bull market in equities, and gradually rising interest rates makes the start of 2018 a good time for businesses to determine if their hurdle rates have shifted.
According to the textbook calculation of the weighted average cost of capital (Wacc) between debt and equity, changes in US Treasury yields and in the corporate tax rate have immediate formulaic effects on the rate that investment projects must exceed to generate shareholder value.
The tax deduction from interest expense is suddenly worth less, and deductibility of interest expense is also capped by law. This makes debt capital notionally more expensive. The theoretical impact of recent events are trickier to parse for the cost of equity. According to the capital asset pricing model, the jump in 10-year US Treasury yields (up from roughly 2 per cent to 2.5 per cent in the second half of 2017) makes equity capital more expensive, by raising the risk-free rate.
There is no explicit mention of corporate tax in the cost of equity equation. However, the surge in US equity prices on the back of the tax cuts and the accompanying rise in price-to-earnings ratios indicates that stockholders are in effect demanding a lower rate of return.
How this give and take on cost of equity and cost of debt balances out will be one of the great questions of the year. It is clear that companies will be awash in more cash. How they deploy that cash will show whether their cost of capital has changed. More spending on capital projects, wages and M&A signals a lower hurdle rate. A dividend and buyback windfall for shareholders suggests that baselines have not really moved. With no clear cut evidence that the cost of capital has fallen — the opposite seems more likely — or that companies are in any way capital constrained, expect shareholders seeking near-term payouts to be the big winners this year