SOURCE: IPIX™ Used with permission from Interactive Pictures Corporation. www.ipix.com.
10 The Cost o f Capital
General Electric has long been recognized as one of
the world’s best-managed companies, and it has
rewarded its shareholders with outstanding returns.
Given its performance, it is not surprising that GE is
always at or near the top of the list of companies in
generating EVA. Thus, GE has been able to consistently
find projects that earn more than their costs of capital.
Estimating the cost of capital for a company like GE
is a fairly straightforward exercise, but it does require
judgment. Since GE’s capital comes largely from equity,
its cost of capital depends to a large extent on the cost
of its equity, which is in essence its shareholders’
required return. One must recognize that when investors
purchase GE stock, they are investing in a company that
operates many different divisions throughout the world.
Each division has a different level of risk, hence a
different cost of capital. GE’s appliance division’s cost of
capital is likely to be different than that of its NBC
subsidiary, or than that of its aircraft engine division.
Likewise, an overseas project may have different risks
and thus a different cost of capital than an otherwise
similar domestic project.
As we will see in this chapter, estimating a project’s
cost of capital is an important process, and one that
requires judgment. Companies that manage this process
well will probably produce positive economic value for
n Chapter 2 we discussed the concept of EVA —
Economic Value Added — which is used by an
increasing number of companies to measure
corporate performance. Developed by the consulting firm
Stern Stewart & Company, EVA is designed to measure a
corporation’s true profitability, and it is calculated as
after-tax operating profits less the annual after-tax cost
of all the capital a firm uses.
The idea behind EVA is simple — firms are truly
profitable and create value if and only if their income