RDP 9205: Measuring the Cost of Capital in Australia 5. Conclusions

The cost of capital for an individual firm is the real pre-tax return that is required to justify an investment. The cost of capital can have important macroeconomic consequences. For example, a higher cost of capital will lead to less investment in capital, more use of labour, lower labour productivity and subsequently lower real wages, at any given level of output.

The variety of methods employed in this paper, and the other studies surveyed, provide a wide range of estimates of the cost of funds and consequently the cost of capital. These estimates vary quite markedly and do not seem to move closely together. For this reason a definitive measure of the cost of capital is not presented in this paper. The major problem with searching for the “best” measure of the cost of capital is that it is impossible to tell, even with the benefit of hindsight, whether the estimates of the cost of capital are empirically correct by some objective standard. An area for future research would be to test whether some of the alternative measures in this paper are more “useful” in predicting movements in investment or other economic variables. However, such tests would be joint tests of the pertinence of the particular series and the validity of the economic model into which they were fed.

Many companies, especially smaller firms, use ‘rules of thumb’ rather than calculations of discounted cash flows in assessing investment projects. Some common examples are average rate of return and payback period. Freeman and Hobbes' (1991) survey of large Australian companies showed that, while around three-quarters of firms used discounted cash flow measures for investment evaluations, many of them also employed payback period as a secondary method of evaluation. Around a quarter of firms only used payback period and average rate of return. These ‘naive’ procedures were more likely to be used for atypical or low value projects.^[25] With recent falls in inflation and interest rates, rules of thumb applied to nominal cash flows should also be adjusted to avoid rejecting viable investment projects. For example, a ten year project generating constant real annual cash flows that is just acceptable when inflation is 12 per cent and the cost of funds is 20 per cent would have a payback period of 5 years. If inflation falls to 2 per cent and the cost of funds to 9.3 per cent the project is equally acceptable but the payback period is now stretched out to 7 years. Reliance on a payback period rule derived in past times of high inflation will result in worthwhile projects being rejected if not modified for a low inflation environment.

Inter-country comparisons of the cost of capital should only be made with a great deal of caution. Comparisons should only be made among estimates using the same, and plausible, concepts and methodology. Even then, there are important differences in accounting conventions across countries which will prove to be important if accounting data are used.

The cost of capital is not meaningful if considered in isolation from the availability of finance.^[26] It would be helpful to know about any impediments facing Australian firms in the equity and capital markets and whether there are any unseen costs that are not fully reflected in a measure of the cost of capital. In particular, it would be interesting to identify whether there are differences in access to sources of capital among firms and to ascertain whether smaller firms face particular disadvantages.

Footnotes

A comparison with an earlier survey by Lilleyman (1984) shows that the use of more sophisticated measures is increasing over time. Freeman and Hobbes' results accord with those from overseas studies. A study for the U.K. by Pike (1988) showed that while 84 per cent of firms use discounted cash flow measures in investment appraisals, payback period is used even more frequently. In Moore and Reichert's (1983) survey, while 86 per cent of large U.S. firms mainly used discounted cash flow measures, a similar proportion were also using methods such as payback period or average rate of return which ignore the time value of money. Oblak and Helm (1980) surveyed multinational corporations and found three-quarters of them made primary use of discounted cash flow measures while the others mainly used payback periods and accounting rates of return. Payback period was an important secondary measure. [25]

See Industry Commission (1991) and Chapter 15 of House of Representatives Standing Committee on Finance and Public Administration (1991) for a review of the availability of finance to Australian business. [26]