A Losing Formula

Volatile financial markets can wreak havoc with your cost-of-capital calculations — and possibly skew your investment decisions and financial results.

But he notes that such increases could boost the size of impairment charges at companies or could trigger further analysis related specifically to goodwill, potentially resulting in a write-down where one might not otherwise have been necessary. That’s because a company’s cost of capital figures into the rate at which it discounts cash flows to determine fair value. Last year, he speculates, most companies probably saw a 1 to 2 percentage point increase in the discount rates they use for that calculation.

Terex itself took a $459.9 million impairment charge for goodwill in the fourth quarter of last year, but that represented a write-down of the entire amount of goodwill in question, Widman notes. Accordingly, the discount rate in that case was a moot point.

At Caraustar Industries Inc., an $820 million paperboard producer, senior vice president and CFO Ron Domanico has addressed the cost-of-capital conundrum by abandoning, at least for now, the idea that any one number can cover every situation.

“In the past, we had one cost of capital that we applied to all our investment decisions,” Domanico reports. “Today that’s not the case. We have a short-term cost of capital we apply to short-term opportunities, and a longer-term cost of capital we apply to longer-term opportunities. And the reality is that the longer-term cost is so high that it has forced us to focus only on those projects that have immediate returns.”

Domanico embraced this dual approach largely to account for the vast spread that has erupted between rates on short-term and long-term debt. Caraustar can borrow against its bank credit revolver at the lower of prime plus 4% or LIBOR plus 5% — a reasonable bogey for deciding, say, whether or not to take a 2% discount on a vendor invoice by paying early. But that’s hardly a good benchmark for a $3 million equipment purchase. Hence, Domanico says, his separate, long-term cost-of-capital calculation takes into account the 12%-plus rates Caraustar would face today if it were to borrow long term.

One way CFOs can double-check the reasonableness of their cost-of-capital calculations, Grabowski says, is by comparing the number they get to a rough estimate based on the yield on the company’s bonds (as opposed to Treasury yields) plus an average equity premium of, say, 4%, or perhaps more — maybe 7% for non-investment-grade companies.

“When you’re done with your calculations, ask if the results make sense,” he says. “During stable periods this may not be a difficult task, but at times like these, many companies may come up with nonsensical answers. Ask if your risk has changed. If it has, your cost of capital should be higher.”

Randy Myers is a contributing editor of CFO.

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