Management SummaryStern Stewart Research // Volume 49

A booming economy, gushing cash flows and abundant liquidity are usually cause for investment and growth. It also appears that raising „cheap“ debt is now much easier than before. And finally, return on equity can be driven even higher using special dividends and stock buybacks. But what would be the price of such behavior?
Whether it is the aftermath of the recent crisis or a sober view to the future: In either case, many CEOs and CFOs currently appear to be cautious and are rarely taking advantage of their newly regained financial leeway. Some are even going so far as to drive down their debt further, thereby increasing the percentage of equity in their company balance sheet. The reason for this caution is probably the expectation of many corporate managers that capital could once again be in short supply, making it more than ever a strategically relevant asset. However, according to established theory, an increase in the percentage of equity in a company‘s capital structure should inevitably lead to an increase in its cost of capital. But is that really true?
The answer to this question is critically important for the financial management of the company, both for its financing as well as for the internal allocation of capital. The following key insights must be taken into account:

1. Capital will soon be scarce and expensive once again
2. The average cost of capital rate is not suitable for optimal management of capital
3. The risk and maturity of assets determine the cost of capital
4. Portfolio management requires the use of a differentiated and dynamic cost of capital
5. The capital structure will be optimized when the largest possible strategic flexibility is considered

CEOs and CFOs should use the current calm phase in the capital markets to acquire a comprehensive view of the individual and riskadjusted cost of capital of their business activities and individual assets. The benefit of such an effort may not yet be apparent. But those who establish the proper ground work now will surely benefit when the next phase of scarce capital begins.