The Cost of Capital (2)
by MaestriGE also invests by acquiring other companies. In recent years, GE has spent billions annually to acquire hundreds of companies. For example, GE recently acquired Marquette Medical Systems, Stewart & Stevenson’s gas turbine division, and Phoenixcor’s commercial equipment leasing portfolio. GE must estimate its expected return on capital, and the cost of capital, for each of these acquisitions, and then make theinvestment only if the return is greater than the cost.
How has GE done with its investments? It has produced a return on capital of 17.2 percent, well above its 12.5 percent estimated cost of capital. With such a large differential, it is no wonder that GE has created a great deal of value for its investors.
Most important business decisions require capital. For example, when Daimler-Benz decided to develop the Mercedes ML 320 sports utility vehicle and to build a plant in Alabama to produce it, Daimler had to estimate the total investment that would be required and the cost of the required capital. The expected rate of return exceeded the cost of the capital, so Daimler went ahead with the project. Microsoft had to make a
similar decision with Windows XP, Pfizer with Viagra, and South-Western when it decided to publish this textbook.
Mergers and acquisitions often require enormous amounts of capital. For example, Vodafone Group, a large telecommunications company in the United Kingdom, spent $60 billion to acquire AirTouch Communications, a U.S. telecommunications company, in 1999. The resulting company, Vodafone AirTouch, later made a $124 billion offer for Mannesmann, a German company. In both cases, Vodafone estimated the incremental ash flows that would result from the acquisition, then discounted those cash flows at the estimated cost of capital. The resulting values were greater than the targets’ market prices, so Vodafone made the offers.
Recent survey evidence indicates that almost half of all large companies have elements in their compensation plans that use the concept of Economic Value Added (EVA). As described in Chapter 9, EVA is the difference betw een net operating profit after-taxes and a charge for capital, where the capital charge is calculated by multiplying the amount of capital by the cost of capital. Thus, the cost of capital is an increasingly important component of compensation plans.
The cost of capital is also a key factor in choosing the mixture of debt and equity used to finance the firm. As these examples illustrate, the cost of capital is a critical element in business decisions.
Taken From : Five-Minute MBA – Corporate Finance
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