Cost of Capital
In today’s context it is even more important for business to have a clear view about the cost of their
capital. Most costs in a business are readily identifiable and to some extent manageable. The managers will know how much they are paying for materials and salaries and premises. But before they can establish their selling prices they need to have some idea of their cost of capital and the expenses associated with funding the assets of the company. The idea could be illustrated with a small example. Suppose the liabilities side of the balance sheet of a business unit: is as given in the table 1.
The company's 1000 shares are trading at 45p each and last year the company produced net income of ?50 after paying 40% tax. What is the cost of capital? In problems like this the standard technique is one of weighted averaging with certain adjustments. The cost of the debt is easy to determine and the other current liabilities and the deferred taxation have no costs attached to them. 7% is being paid on the preferred stock but this is an after-tax charge and the true cost, grossed up for tax, is 7% divided by (1 - 0.4) = 11.7%. The cost of the equity is normally determined by reference to the market rather than the book value of the shares and the cost is the attributable profit, again pretax. One thousand shares @ 45p are worth ?450 and the attributable profit is ?50 divided by (1 - 0.4) = ?83.3. Tabulating all this, we calculate the 'weighted average cost of capital' as given in table 2.
How realistic and valid is this approach? As well as for pricing, managers use the cost of capital calculation for assessing potential investments. Any activity which involves assets on the balance sheet may be assumed to cost, in our example, 12.1% on those assets each year, and if the activity does not earn that, pretax, before the capital costs are deducted, it is not paying its way. Actually, an investment will have to deliver considerably more than that to cover the element of 'dead capital' tied up in non-productive assets such as administration and central management office space. Against that, many capital type investments bring with them up-front tax advantages in the form of investment credits, and on a discounted cash flow basis these bolster up the return on assets employed.
Cost of capital is a real cost and one that cannot be ignored. A business failing to reckon that capital has a cost will inevitably suffer unexpected, avoidable losses or at the very least will find its share price sliding, with negative implications for its ability to raise new money.
Our calculation implicitly suggests that the book value of equity is not a helpful number and that we should be looking at the market value. The market value of each share multiplied by the number of shares outstanding is a poor guide to the real worth of the company and anyone attempting to buy control of the company would usually expect to pay a substantial premium. The day to day share price is a marginal trading price, not an evaluation of the whole. The calculation also implies that ?1075 is the value of all the company's assets, a seriously questionable assumption.
Secondly, deferred taxation is treated as a costless liability. This is not quite fair. In many cases, deferred tax is never likely to be paid and it is in reality largely a subdivision of equity. It is only legitimate to consider it a costless liability in so far as it represents an interest free loan from the tax authorities.
Finally, the cost of equity is an imponderable. Instead of the earnings method used above, some practitioners employ the dividend yield (on market capitalization) plus the growth rate as the percentage cost of equity, an equally logical attitude to a virtually insoluble problem. What rankles is the implication that additional equity finance could be raised at the calculated cost of equity.
According to corporate finance theory, it is an aim of management to minimize the cost of capital by balancing the relative quantities of debt and equity in the balance sheet. An inappropriate balance sheet structure is damaging because too much equity is invariably expensive and too much debt increases the cost of that debt as the company is perceived to be risky and reduces the share price which pushes up the cost of the equity. Broadly speaking, we agree with this perception. What is not acceptable is that the managers or the investors in a large company, with perhaps two dozen different debt issues and several classes of equity, are capable of calculating the cost of equity with any precision.
The conclusion is that while it makes sense for a company to try to ascertain its weighted average cost of capital and for analysts to try to second guess it, the real world is too complicated for the calculation to be done with any precision. Our impression is that balance sheet structure is monitored by ratios and determined in part by what portions of equity or debt the market can be expected to swallow at the time that the company needs the money. If a company is heavily borrowed, (and remember the world sees only the year end, window dressed balance sheet) comments in the press refer to this higher gearing or leverage, never to a high cost of capital. A low share price is a deterrent to equity issues because of the consequent dilution of earnings, but when the share price is high the effect of dilution is deemed to be of no consequence.
(Mundul is CEO of Standard Chartered Bank Nepal Ltd.)
Mental Evolution & Aspiring Organizational Leaders
There are flaws in our minds that prevent us from being rich and happy. Millions
of years of evolution have perfected our bodies, transforming them from unicellular amoeba into the Homo Sapiens of today. But the mind, by comparison, is barely fifty thousand years old. The last few thousand years have seen the mind grow exponentially, evidenced by mankind’s drastic leaps in science and technology. Yet only a handful of great thinkers like Copernicus, Newton, Edison, Darwin and Einstein have emerged and revolutionized the way the rest of us think and see the world. It is time that more people follow suit in this ‘intellectual evolution’.
Its forerunners will be none other than you – organizational leaders.
You will be the Buddha, the Jesus and the Mohammad of this new generation: you will lead your employees to a new way of thinking and consequently of living and working. One Bill Gates or Dhirubhai Ambani is not enough to overcome the obstacles miring Nepal and put it on the world map of great prosperity: more and more business visionaries and empire builders are needed in more and more sectors, using their minds in the most powerful ways.
All of this sounds great but unless we correct our mental frameworks for perceiving the phenomena in the world, for relating to one another, for building families and for running companies, we will miss the mark.
Correct framework to come to conclusions
I was initiated in this mind-stuff when I read the book “Fifth Dimension” by Peter Senge. Thereon I realized that in terms of mind, man in general was like a baby walking on his fours. Senge brings us to the concept of ‘ladder of inference’. Through this analogy he is trying to explain to us in a scientific manner what the age-old Nepali proverb “Don’t run after the crow just on hearing someone say that the crow has taken away your ear” teaches. Simply put, the message is: “Don’t jump to conclusions without analyzing things”.
Stephen Covey, author of the best selling self-help book “The Seven Habits of Highly Effective People”, cites an example of this. He was conducting a seminar in which his mother was part of the audience. In front of her were two men. They enraged her because they talked to each other throughout the entire Seminar. She concluded, “How rude these men are!” They also happened to be Asians and later she complained to herself, “Asians are noisy.” This is a habit of generalization, or “running after the crow.”
Later on she reported this matter to her son, Stephen. He checked out the matter by asking the two Asians: he did not want to directly accept any conclusion. This is the sign of a mind that has undergone evolution. This is what he found out: one of the two did not understand English and the other was his translator!
Some of us studied science and the concept of ‘ladder of inference’ is best understood in terms of science. Before coming to a conclusion under scientific process, first an experiment is set up and then the results are observed. From these observations an analysis of the causes (inference) is made. Finally, on the basis of these inferences, a conclusion is drawn. Although we are aware of this process of thought formation academically, it is very hard for us to apply this in real life, even in small matters, particularly under stressful conditions.
This shortcoming of the human mind to climb down the ‘ladder of inference’ (which we can define as the ability to first observe an event from all angles, then try to find out where it is coming from and then finally come to a conclusion), is most apparent at the family level. The father refuses to buy a toy for the child who wants it desperately. This is an event. Ideally the child should make a complete observation: what tone is he using, what is his body language, has he had a bad day ? how is the financial standings of the family ? what are the current family priorities for expenditures ? how does the father view the request for the toy? Then the child should link the various observations so as to form a causational chain as follows: “Father does not see how important the toy is for me and it is natural as he thinks from an adult’s point of view. Also currently he needs to immediately buy something expensive for the house. On top of that the savings are dwindling as we are spending so much on our education and housing loan. In addition he had a stressful day at work because he lost a big tender. Even though he said he would not buy the toy, his body language and tone of voice seemed almost apologetic.”
Finally the child should come to a conclusion like this: “I should not expect so much from my father. When he will be able to afford it, he will buy me the toy. Instead of nagging him for the toy, if I inspire him to win more tenders, he will earn more save more and thus he can buy me lots of toys. Even though he refused to buy it for me now, he is a great dad.” The child would be able to say all this because he understands his dad fully by virtue of having climbed down the ladder of inference or used scientific reasoning in a mundane daily event. Finally he can make a generalization, “Sometimes life is sour but in the long run it is for your own good.”
However, we know it is absurd to envision any child thinking in this fashion. Still, a day will come when children shall be born with such mental circuitry thanks to the DNA of enlightened parents.
In the present mental state, the child, upon being denied the toy, would come to one or more of the following conclusions:
1. Dad hates me
2. I am unworthy
3. I will never get what I want
4. Only if I throw a tantrum will I get anything in this home
5. I must grow up fast and earn on my own to get what I want
These conclusions will lead to generalizations such as:
1. All fathers are stingy
2. Life is miserable
3. You can’t get what you want in life
None of the above five conclusions are healthy as they are like dental plaque waiting to make cavities in the teeth once sweets (generalization) get stuck and react chemically.
We can laugh it off when the matter is about a child. But in reality 99% of mankind is guilty of jumping to conclusions and making baseless generalizations. As a family person, I have seen that most of the quarrels, break-ups and misunderstandings originate as a failure to use the ‘ladder of inference’. As a management consultant, I have seen poor performance and low motivation on the part of employees who come to the wrong conclusions and make false generalizations about their boss, their companies and their clients. The same mental shortcoming overshadows the owners and, to a lesser extent, the managers (which is perhaps due to experience) affecting their leadership and judgment. The higher you rise up in the organizational hierarchy the more you see people who are less fatalistic. They don’t say “I already know’, ‘I am right’ and ‘I can’t be wrong’. They say, ‘Could it be that what I think is a fact is just a lie?’, ‘How can I be sure I am right?’ and ‘What could prove I am wrong?’
My point is simple: if we want a happy family and great teamwork in our organizations we must train our minds to use the ladder of inference in every situation, no matter how trivial the matter may be.
No right, no wrong
My mother always bugs me because I leave the toilet, like all men do, with the seat open. I thought I was wrong and she was right. Her reasoning was irrefutable, “In this way the smell will not disperse in the air and it will not stink.’ But still being a son, I used to neglect this request to tease her.
When I was abroad, I was renting a room from an old couple. Having been taught by my mother that closing the seat cover was the right thing to do, I did exactly so because I had no intention of getting on the wrong foot with the old folks.
Who is right? Who is wrong? What is right? What is wrong?
To my surprise in a few months, the old man came to me embarrassed and said, “Don’t close the toilet seat. Keep it open.’ Before I could fix my mental fuse he continued, “In this way, the smell will get absorbed by the water in the pan and it will not stink.” My mind again short-circuited. Who is right? Who is wrong?
My new-born baby was being taken care of by an elderly relative. She put a veil over his face. She reasoned, “The baby has been used to living in darkness in the mother’s womb. It will thus prefer a darker setting.”
She left and my mother came and she exclaimed why had we put a veil on the face of the baby. Before I could answer, she reasoned, “The baby has been used to living in darkness in the mother’s womb. It will be tired of darkness and prefers light for a change.”
Who is right? Who is wrong? What is right? What is wrong?
The definition of right and wrong differs from one culture to another. Since organizations also have cultures, I think the best policies are:
1. No right, no wrong
2. Respect each other’s perceptions
3. Don’t get caught in the right-wrong debate trap unless it is a matter of life and death
4. If it is a matter of life and death, do or die, use the scientific approach (as explained above) to determine the best practice
5. Bring in the concept of ‘perception’ to explain differences like the picture designed in Harvard University some time back, in which there is both a young woman and an old woman, but only one of them can be seen at a time.
Finding meaning
As a first-time father, my ears have been forcefully fed with so many horrible baby-stories that at one point I almost felt I could become another such story. Every parent is filled with dread during pregnancy as a result of the recounting of these cases that occurred to someone’s relative or friend, making it even more real and pressing. When two would-be couples talk, they do so in terms of such cases. It is hard to get out of this kind of mental fixing. What if it happens to you also? What good will worrying do?
Similarly, organizations are plagued with many stories that are broadly of two types:
1. There was this staff member who got fired for nothing.
2. Look at her; she is in this position for 15 years doing the same thing since she started.
On the good side they offer precautions to take. On the bad side, they make false claims and skew the truth or fact. Stories are vivid and compel us to find a meaning. The problem is that we find destructive meaning because the stories themselves are ill conceived.
I advise my clients to make use of stories to convince people, create a grapevine in which such stories will be transmitted to all employees, fill the air of the company with the obvious messages of empowerment and rewards for it, make the working environment as a consequence surreal like a forest in a desert. Done with enough research (to collect and fine-tune the stories), untiring management-by-walking-about (MBWA) and fanatic passion, this story telling approach works as most multi national corporations in the Fortune 500 will tell you. Look at the ads of Fed Ex where the employees go to great lengths, overcoming all obstacles, to get the package to its destination on time.
Great CEO’s know that the human mind has a weakness to derive meaning from stories, to believe those derivations and to act based on them. Great leaders since early days used this weakness of human mind to their advantage by telling their followers favorable stories to establish the leaders’ rules. Kings of past embraced religion less for piousness and more for the fables they brought. Even today we are transfixed with stories of kings and their mighty power. It was a leadership function well done.
What I am driving at is that our minds find it hard to do comparative studies of various stories to see whether they have similarities, how they differ and what message the composer of the story wanted to send and why. In any master’s degree course we were taught this skill of comparison on a large scale, in PhD this skill is further pushed to its limits, adding more materials to compare before making the thesis. Yet, as mentioned earlier, although some of us have built a more advanced mind, it is still limited to academics. We are not able to use it to find out the truth.
In the above examples, parents and employees ideally should collect as many stories as possible, find out how many similar cases there are, how they differ and why, what they have in common and why, what conditions were fulfilled and what was missing, and how it is different and how it is similar to their own situations. Only then should they attempt to find the meaning. Then the precautions they take will be truly effective. Otherwise stories paralyze. The example is the employee who bases his conviction only on one particular case and prevents himself from performing like a star in fear of not being recognized and thus getting disappointed. This is the result of the message that he derives from the story.
In the end
What we discussed are only a few of the flaws of the human mind inherent in its present state of evolution and the mental actions we must take to correct them. When you will correct these flaws, you shall be enlightened, happy and rich. As all great men have said, “Wealth starts in the mind first.”
Shrestha is Senior Trainer/Advisor, Standard Icon Pvt. Ltd
