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Handbook of Budgeting, 6th Edition by William R. Lalli

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CHAPTER FOURTEEN

Profitability and the Cost of Capital

Mike Kaufman

Management Advisory Group

INTRODUCTION

Developments over several decades have focused attention on the cost of capital as a management decision factor.

  • Our loss of international competitive position, although largely regained, has been partially blamed on a relatively high cost of capital.
  • Choices among emerging technologies with different cash flow profiles may depend on the cost of capital used for discounting.
  • The rise of multibusiness corporations has led to the need to estimate divisional cost of capital.
  • The desire to measure and improve performance has caused many corporations to link costs of capital to executive profit goals and executive compensation plans.

International position and technological choices reflect the quality of new capital investment. However, performance evaluation standards and divisional costs of capital should also consider capital already committed.

This chapter considers that question of how to manage existing investments over a normal planning horizon. In that context, it is important to address the question of determining the cost of capital, at both corporate and division levels.

Traditionally, companies have relied on computations of earnings and earnings growth to gauge the performance of a division and its managers. More recently, firms have realized that price/earnings ratios do not reflect shareholder’s required returns. This has led to increased popularity of certain ...

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