Cost of Capital: Applications and Examples, + Website, 5th Edition

CHAPTER 33

The Role of the Cost of Capital in EVA and in Corporate Value-Based Management

G. Bennett Stewart III

Introduction

How to Score the Business Game

Abandon ROI

Cash Flow Must Go

EVA Is the Measure of Net Present Value

Implications

Practical Innovations Are Helping

Best-Practice EVA

INTRODUCTION

The cost of capital is a critical but invisible dividing line between corporate success and failure that if properly implemented can make an enormous contribution to the quality of corporate management and shareholder value.

The key insight is that capital has a cost because capital is a scarce resource. It is limited in the aggregate to the amount of money that individuals and companies choose to save (less the money siphoned off to fund government deficits). For any one company to access the finite pool of savings and fund growth, it must displace another company or an entrepreneur that is also eager to raise funds for a worthy cause. The cost of capital is the market's cop—it tells managers and investors what growth and what investments should not be funded, so that other more worthy endeavors can be. It is also the market's motivator—it rewards companies and raises share prices in firms that can deliver more customer value with less investor capital.

To see this, examine the following grid, where the amount of capital investment and savings dollars are plotted from left to right, and the prospective rates of return on investment projects and prevailing market interest rates ...