The cost of capital as a strategic decision making factor
Joost Geginat, Beatrix Morath, Roland Wittmann, Philippe Knüsel
2006
Risk-adjusted capital allocation remains a major challenge to many companies. This is the finding of a study of 72 large companies in Germany and Switzerland conducted by Roland Berger Strategy Consultants in 2005. The study reveals what actually happens in practice, discusses the strengths and weaknesses of the most common approaches, and contributes to finding a more workable, effective solution.
Companies are evidently aware of the need to act. Capital is a scarce resource. And now that returns on capital can be readily compared on an international scale, capital naturally follows the most lucrative investment opportunities around the globe. Competition for this scarce resource has therefore become fiercer than ever. In the ensuing battle to secure funding, capital allocation considerations therefore play an increasingly important role. A further factor is that both investors and companies are these days better sensitized to business risks. In the 1990s, shareholder value strategies heightened people's awareness of whether businesses add or destroy value. Companies have since felt compelled to clearly identify the risk exposure of their capital earnings and their cost of capital, and to model the results in their risk management systems. The problem, however, is: How can divergent risk structures in different lines of business be adequately reflected in the calculated cost of capital?
The aim of this study is to help find a workable, effective solution to these problems. It outlines current practice in capital cost allocation at German and Swiss companies, explains promising approaches, and identifies those factors that determine the success of the WACC model when it is applied to individual business lines.
72 CFOs and chief accountants/controllers from the top 500 companies in Germany (according to Wirtschaftswoche 2004 rankings) and the top 100 companies in Switzerland (according to Bilanz 2004 rankings) took part in the study.
