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Non-Executive Director, Finance & Strategy Professional, Independent Trustee & Mentor helps firms to scale and internationalize.
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Lockdowns imposed by a number of nations throughout the world have hastened the use of digital technology in most industries. The corporate environment has become more complex as a result of this. Companies’ strategic initiatives are heavily influenced by their financial and market standing prior to the present crisis. On the one hand, some businesses may need to go into “survivalist” mode, focusing on internal cost cuts and non-core asset divestitures; on the other hand, businesses can focus on external development prospects through mergers and acquisitions.
What is required is for these decisions to add value to the organization. That is, if an investment earns less than its applicable cost of capital, it will lose value. Professor Aswath Damodaran of NYU Stern School of Business discovered that in 2016, 55 percent of 41,889 worldwide enterprises generated less than their cost of capital. Companies must have a strong grasp of their cost of capital, and leaders must use this knowledge to make decisions.
Value can be created by focusing on actions that will boost return (such as reviewing operational models and looking for savings), lowering the weighted average cost of capital (WACC), or a combination of the two. When striving to identify essential tasks, areas for improvement, and a baseline standard for returns arising from these decisions, both “survivalist” and “expansionist” firms should apply this effective mechanism.
WACC is primarily made up of a company’s cost of debt and cost of equity, weighted by their relative use.
The Price of Debt
ADDITIONAL INFORMATION FOR YOU
Debt is always cheaper than equity, according to finance fundamentals. As a result, the logical choice to lower the cost of capital would be to take on more debt. Changing the company’s capital structure is a viable option, but it must be carefully controlled. Debt carries the risk of default, and the cost of that risk must be factored into capital structure decisions. In other words, adding additional debt to a company’s capital structure is beneficial only up to a point, after which the risk it introduces outweighs the gain.
Finance managers may look into debt-related mechanisms like as futures and swaps in order to reduce the risk of debt default, albeit these instruments are more likely to apply to major corporations than to small, medium, and micro businesses.
Equity Investment Costs
The cost of equity is essentially the return required of a typical equity investor in a company, and it is proportional to the risk the investor sees in their investment. As a result, businesses must evaluate how to reduce their risk in order to attract more inexpensive capital.
The operating leverage of a business refers to how vulnerable it is to fixed costs vs variable costs. The higher a company’s relative fixed costs are, the more vulnerable it is during downturns like the current one. Companies should analyze their costs and, if possible, try to cut fixed costs. Outsourcing specific functions, entering flexible pay contracts, and negotiating flexible leasing terms are all examples of this.
Another aspect that influences the cost of equity is the nature of the company’s products or services. When compared to less discretionary enterprises, a company that sells discretionary products (high-price elasticity, specialty, etc.) is at greater risk during downturns. As a result, developing marketing tactics that ensure products fit client needs while also increasing brand knowledge and loyalty is critical. For investors, the more variable predicted cash flows are, the higher the risk they perceive and the higher the cost of equity.
Creating Value
The company’s focus should be on generating higher returns once the cost of capital has been identified. New investments in high-quality assets/projects and efficiency from existing assets are the two key sources of growth. As previously stated, value is produced when growth creates surplus returns. The focus would then be on extending and maintaining the era of value-adding growth.
Aggressive cost-cutting measures are frequently used to generate value from present assets. However, this might sometimes overlook long-term value, therefore executives should instead concentrate on improving margins carefully. This can also be accomplished by: o Selling off assets that are losing money.
o Investing in assets that earn below-cost-of-capital or marginal returns.
o Increasing value through improving working capital management.
o Better credit policies are being implemented.
o Examining the maintenance and capital expenditure replacement program to see if expenditures can be deferred.
o Taking a look at the tax approach (which is also an effective risk management activity). This could involve transfer pricing techniques or even shifting income to lower-tax jurisdictions, lowering the tax rate and enhancing cash flows.
A business cannot save itself from failure. There’s only so much efficiency that can be unlocked before the attention needs to shift to other areas in search of higher returns.
It is critical to ensure that predicted returns continue to outperform the cost of capital when making new investments. Managers should evaluate new investments and projects critically in order to have a comprehensive grasp of expected returns. They must then guarantee that these excess returns are maintained for as long as feasible after an investment has been made. A corporation should therefore ensure that it has a defendable competitive position (also known as a competitive advantage) by using a brand name, legal projections, patents, and inventing new switching cost advantages.
The reinvestment rate must be evaluated during this process of excess return sustainability. This could be reinvestment in order to maintain growth or attain specific returns. External finance will be necessary in circumstances where excess returns can be achieved but the reinvestment required cannot be generated internally. This can take the shape of debt or equity and, as stated at the outset of this article, may have an impact on the firm’s capital structure.
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