Academic journal article Business Economics

Cost of Capital: Reflections of a CEO

Academic journal article Business Economics

Cost of Capital: Reflections of a CEO

Article excerpt

*George N. Hatsopoulos is Chairman of the Board and President, Thermo Electron, Waltham, MA. The author gratefully acknowledges the invaluable assistance of Dr. James M. Poterba, Professor of Economics at the Massachusetts Institute of Technology, for his many contributions to this article.

1 See footnotes at end of text.

After some background on the cost of capital concepts, the author summerizes the latest literature on the evolution of the cost of capital gap between the U.S. and other industrialized nations, showing how this gap has affected innovation in U. S. industry. He describes methods used to reduce the cost of capital for his company. Then he lists the types of actions the federal government must take to close the gap in the cost Of capital between the U.S. and its principal foreign competitors.

OVER THE PAST decade, many U. S. industries have lost their international market positions to Japan, our principal industrial competitor. I am convinced that the major cause of this alarming trend is the difference in cost of capital prevailing in the United States and Japan. My coauthors and I have tried to articulate this view in several articles,(1) the first published in 1983. To our surprise, we found some skepticism concerning this thesis among many successful businessmen.

The purpose of this article is to promote a better understanding of issues relating to the cost of capital.

DEFINING THE COST OF CAPITAL

In a world free of both taxes and risk, corporations could finance any and all projects through borrowing, provided that those projects were sure to return more than the interest rate demanded by lenders. In such a world, the cost of capital would be the interest rate. Moreover, if competition were "perfect," the return on all projects would be the same, and it would be identical to the cost of capital.

In the real world, of course, things are quite different. Taxes have to be paid under rather complicated rules, and predictions cannot be made with certainty. Therefore, all projects involve risks, and those risks represent a significant burden to prospective investors. At some price, lenders are willing to bear a certain level of risk. In practice, most of that risk is borne by holders of equity.

Equity holders are represented by corporate managers whose obligation is to provide, as best they can, their investors' return. It follows that corporate managers should invest only in those projects that promise to return a pretax profit sufficient to provide the taxes required by law, the interest required by lenders, and the dividends and capital gains required by equity holders. The cost of capital for an investment is the least return that satisfies all the requirements cited above.

In making investments, corporations use two sources of funds: equity and debt. Each source differs in its exposure to risk, in its taxation, and its cost. The use of equity exposes a corporation to the least risk, because it involves no fixed obligation to provide either returns or repayments. For the same reason, the supplier of equity funds is exposed to the greatest risk. On the other hand, use of interest-bearing debt exposes a corporation to the greatest risk, and the supplier of funds to the least, because it involves a fixed obligation to provide returns and to repay the funds.

The two sources of funds impose different corporate tax burdens on the return to investors. Payments to equity holders are taxed, whereas payments to debt holders are not. As a result, for a given return demanded by investors, the after-tax cost of debt is much smaller than the cost of equity.

Stockholders invest in corporate equities in order to have future monetary returns. Corporations invest the stockholders' equity in order to make an after-tax profit. Part of that profit is paid back to investors, and part of it is retained for reinvestment to generate progressively larger profits. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed

Oops!

An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.