Academic journal article Business Economics

Some Financial Perspectives on Comparative Costs of Capital

Academic journal article Business Economics

Some Financial Perspectives on Comparative Costs of Capital

Article excerpt

*J. Fred Weston is Professor Emeritus of Managerial Economics and Finance, Anderson Graduate School of Management, University of California at Los Angeles, CA. He also is an Associate Editor of this Journal. The author thanks Clement G. Krouse for considerable guidance in preparation of this article.

1 See footnotes and references at end of text.

Empirical studies of international cost of capital comparisons have taken two related form. One is to compare weighted average costs of capital (WACC) for samples across economies. Sample WACC comparisons may be subject to error because the cost of capital measures may not be applied to appropriate definitions of operating cash flows whose qualities, time-growth patterns, and risk may differ. Comparisons of riskless rates such as yields on government securities ignore relevant risk differences. No financially derived competitive advantage is likely to exist with: (1) no net tax or subsidy differences, (2) capital market and economic integration.

MUCH HAS BEEN written on whether firms in some countries have a lower cost of capital than firms in other countries. This article first reviews the cost of capital measurement methodologies employed in prior studies of financially derived competitive advantage (FDCA). The problems with these studies motivate use of an alternative methodology based on widely accepted models of asset pricing in the literature of financial economics.(1)

THE ANALYTICS OF FDCA MEASUREMENT

One major challenge confronting measurement procedures is whether the samples of firms being compared have similar technology and product market opportunities. Otherwise differences may arise from nonfinancial characteristics rather than financial. In addition to distinguishing between operational and financial sources of competitive advantage, other difficult measurement problems also must be resolved.

The traditional approach to making comparisons of the cost of capital for firms is the weighted average cost of capital (WACC) method measured by:

k = WACC = K[.sub.b] (1 - T) L + K[.sub.s] (1 - L) (1) where k = WACC = weighted average cost of capital

k[.sub.b] = cost of debt

k[.sub.s] = cost of equity

T = corporate tax rate

L = debt at market value divided by value of a firm (V)

In implementing the WACC method it is also traditional to employ a discounted cash flow (DCF) procedure. The combined DCF/WACC method poses difficult measurement problems, as suggested by Table 1. The first issue is whether to use before-tax or after-tax measures. The correct procedure is to start with comparable before-tax operating cash flows, then compare the ratios of the capitalized values to the after-tax cash flows. Differences in types of taxes, kinds of deductions, and administrative policies and practices are reflected in the before-tax and after-tax calculations.

Measuring the cost of debt must take into account a wide variety of factors to establish comparability in samples across countries. The measurement problems are even more difficult for cost of equity comparisons. The time framework for measurements also poses dilemmas. Theory requires that the analysis be forward looking - based on expectations. The available data are mainly historical.

More problems are confronted in calculating the weights. Previous studies of the costs of capital across countries have mainly used historical book weights. But it is an error not to take market values into account. In practice, managements for different combinations of reasons may have some target range as an objective. These subtleties are difficult to encompass in large scale studies.

To illustrate the nature of the difficulties, we shall describe the problems of measuring the cost of equity capital in the DCF/WACC approach. In concept, the cost of equity is the appropriate yield to maturity, k, that equates the expected cash flow streams to the observed price in Equation (2). …

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