Quick, what’s your company’s cost of capital? Not sure? That’s OK — you’re far from alone. Finance executives have long wrestled with that question when establishing hurdle rates for investments. During the last throes of the bull market, with capital dirt-cheap, it didn’t much matter. But the bear market has made capital dear once again, and brought the question of its exact cost back to center stage.
Calculating the price of debt is not the problem: subtract the prevailing interest rate on Treasury bonds from the rate on a company’s equivalently timed debt, and the resulting spread will serve as a perfectly reliable measure of investors’ expectations that the company will default on those obligations. That spread can then be used to establish the returns an investment must produce to satisfy bondholders that the risk of default is worth taking.
The rub comes in trying to reckon the cost of a company’s equity. There is simply no way — yet — of definitively measuring the risk that a company won’t be able to satisfy shareholders as well as bondholders, who after all have first dibs on a company’s assets in the event of bankruptcy. In the absence of a better alternative, for nearly 40 years many academics and finance executives have accepted the capital asset pricing model (CAPM), or some variation of it, as an adequate means of approximating the cost of equity.
Recently, however, proponents of a new methodology have claimed that companies can use options-pricing theory to estimate their cost of equity, and therefore capital, to a far greater degree of accuracy than ever before. Is it time to throw away the old yardstick?
Introduced in 1963 by Stanford University professor William Sharpe, and building on the pioneering portfolio-optimization theory of Harry Markowitz, CAPM was designed to help investors develop a diversified portfolio of assets. (Both Sharpe and Markowitz won Nobel prizes for their work.) But CAPM also found its way into corporate offices as a standard formula for establishing minimum acceptable returns for capital allocation of all kinds, including acquisitions, product development, and restructuring projects.
The trouble is, CAPM isn’t particularly well suited for corporate purposes, as both theorists and practitioners have come to acknowledge. “A square peg in a round hole” is how Tony D. Yeh, a principal in the San Francisco-based consulting firm Pacifica Strategic Advisors LLC, describes CAPM’s application to hurdle rates. He’s not alone. “I don’t think there’s any question that CAPM is not appropriate” to calculate hurdle rates, declares Robert Reilly, managing director of Chicago — based consulting firm Willamette Management Associates.
What’s wrong with CAPM? Yeh, Reilly, and others say the model’s basic flaw is the way it calculates the equity risk premium — the amount of return that equity investors require above and beyond the rate available on bonds.
In calculating this premium, CAPM relies on a measure known as beta, which multiplies the volatility of an asset’s price by its correlation, or the degree to which the price moves in line with prices of other assets. The result works well when the goal is to select assets that serve to diversify a portfolio. After all, an asset’s price may be hugely volatile but pose little risk for a diversified portfolio if it is totally uncorrelated to prices of other assets. (Indeed, a volatile asset will actually decrease a portfolio’s overall risk if other assets’ price movements are in exactly the opposite direction.)