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.

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AUTHORS

Stern Stewart & Co. is the independent strategy boutique. With a truly entrepreneurial team of independent thinking personalities.
The center of gravity of an open universe of cutting edge know-how. Advising clients in strategy, transaction, performance and
transformation.

Stefan Heppelmann

Stefan is an independent thinker and senior advisor mostly in transformation/ turnaround situations. Combining deep financial know-how as a CFA charterholder with two decades of consulting experience he often has the one inspirational idea. Discussing key themes of the executive agenda, he shows his entrepreneurial mindset with great personal involvement. Stefan is a true entrepreneur outside the office as well, managing his own agricultural venture in France and supporting Wend Puiré, an apiculture non-profit organization in Burkina Faso.

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Marcus Middelmann

Marcus is all about ambition and commitment. Not only when it comes to golfing or hunting, but even more when an ambitious transformation project is on the agenda. With a long track record of supporting profitability programs and restructuring initiatives he is aware of the associated pitfalls: But his diligence and his high attention to detail often proved to be priceless in critical situations. Shaped by the culture of a family business, he gives much attention to mutual trust and long-lasting relationships.

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