The Cost of Capital

by Maestri

General Electric has long been recognized as one of the world’s best-managed companies, and it has rewarded its shareholders with outstanding returns. During its corporate life, GE has raised a cumulative $76 billion in capital from its investors, but it has turned that $76 billion investment into a company worth more than $543 billion. Its Market Value Added (MVA), the difference between its market value and the capital investors put up, is a whopping $467 billion! Not surprisingly, GE is always at or near the top of all companies in MVA.
When investors provide a corporation with funding, they expect the company to generate an appropriate return on those funds. From the company’s perspective, the investors’ expected return is a cost of using the funds, and it is called the cost of capital. A variety of factors influence a firm’s cost of capital. Some, such as the level of interest rates, state and federal tax policies, and the regulatory environment, are outside
the firm’s control. However, the degree of risk in the projects it undertakes and the types of funds it raises are under the company’s control, and both have a profound effect on its cost of capital.
GE’s overall cost of capital has been estimated to be about 12.5 percent. Therefore, to satisfy its investors, GE must generate a return on an average project of at least 12.5 percent. Some of GE’s projects are “home grown” in the sense that the company has developed a new product or entered a new geographic market. For example, GE’s aircraft engine division won more than 50 percent of the world’s engine orders for airline passenger jets, and its appliance division recently introduced the Advantium speedcooking oven and the ultra-quiet Triton dishwasher. GE began Lexan® polycarbonate production at a new plastics plant in Cartagena, Spain, and GE Capital expanded in Japan by creating a new life insurance company. Sometimes GE creates completely new lines of business, such as its recent entry into e-commerce. In fact, GE was named “E-Business of the Year” in 2000 by InternetWeek magazine. When GE evaluates potential projects such as these, it must determine whether the return on the capital invested in the project exceeds the cost of that capital.

Taken From : Five-Minute MBA – Corporate Finance

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