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Cost of Capital & Competitive Advantage

Mohammad Ibad Desmukh


25 February 2014
MANAGERIAL POLICY
A firm has a competitive advantage when it creates more economic value
than its rivals


In order to generate economic value, a firm needs to invest in projects (e.g.
Coke invests in a new factory)

Invest in Projects


Raise Capital

The Lower a firms (Cokes) cost of raising capital to finance a project, in
comparison to rivals (Pepsi), the Higher its competitive advantage


Economic Value = Competitive Advantage

Measures of Competitive Advantage
Accounting Measures Economic Measures
Calculated by using information from
P&L and Balance Sheet and compares
return (profit) to industry averages

Examples:
Profitability Ratios (ROA, ROE)
Leverage Ratios (Debt to Equity)



Does NOT include the Cost
of Capital
Compare a firms level of return (profit) to its
Cost of Capital instead of the average level
of return in the industry

Cost of Capital is the rate of return a firm
pays to its suppliers of capital

Weighted Average Cost of Capital (WACC) is
the rate that a firm is expected to pay on
average to all its security holders (debt and
equity) to finance its assets

WACC is an estimate of the Cost of Capital
Estimating WACC

Components
A Firms Debt Rating
Marginal Tax Rate B
Beta C
Risk Free & Market Rate D
1
Firms Capital Structure E
(Stockholders Equity/Total Assets) x Cost of Equity
+
(Debt/Total Assets) x After-tax Cost of Debt
WACC
Cost of Equity = risk free rate + (market rate) x beta
Cost of Debt = (1-tax rate) x (risk free rate)
Managerial Policy
Economic Measures
Economic performance & Cost of Capital (WACC)
Different levels of Economic performance:
1. Above Normal: A firm that earns ABOVE its cost of capital
2. Normal: A firm that earns EQUAL to its cost of capital
3. Below Normal: A firm that earns BELOW its cost of capital
Cost of Capital: Level of performance the firm must attain to satisfy its:
Debt Holders
Equity Holders
1
2
Firms that have a Competitive DIS-advantage generally have Below Normal Economic
Performance

3
Managerial Policy
Reducing the cost of capital through capital restructuring
Recommendations:
Mature companies (Coke) with stable and predictable cash flows as well as limited investment
opportunities should include more debt
Companies that face high uncertainty (Twitter) should carry less debt

1. Strike a balance between the discipline and tax savings that debt can deliver, and the
greater flexibility of equity

2. A company can reduce its after tax cost of capital by increasing debt relative to its
equity

Effect on cash flow:
Carrying debt imposes discipline and increases intrinsic value
Too much debt can reduce intrinsic value by limiting flexibility to make value investments
3
4
Managerial Policy
Making Capital Structure support Strategy
McKinsey & Company
Lower cost of Capital with Optimal Leverage
Managerial Policy
Empirical Evidence
WACC = 8.38
WACC = 8.21
Pepsi has a lower WACC as compared to Coke due to a different capital structure,
which gives it a competitive advantage over Coke
Economic Profit is a measure of performance that compares net operating profit to the total
cost of capital
A positive economic profit tells us that the firm more than covered its cost of capital.
The Lower the Cost of Capital, the Higher the Economic Value / Profit
Invest in Projects
Economic Value (Profit) = Net Operating Profit After Tax - (Capital Invested x WACC)
Raise Capital
1
2
3
4
Competitive Advantage
Conclusion: Net Profit and Cost of Capital
Conclusion
Economic measures of competitive advantage exaggerate the importance of debt/equity
holders at the expense of other stakeholders (customers/suppliers/society etc.)

1. Firm earning at-least its cost of capital means that it satisfies its 2 most important
stakeholders (debt/equity holders)
Lack of information can create difficulties in calculating WACC (if firm is privately held)
2
3
Advantage
Limitations
Managerial Policy
Advantages & Limitations of economic measures
Thank You
Managerial Policy
References
McKinsey on Finance (Winter 2006)
Strategic Management & Competitive Advantage (Jay B Barney)

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