In response to the Great Recession, central banks continue to engage in massive monetary stimulus to artificially depress the costs of capital. Many commentators have expressed concerns (and I concur) about the inflationary forces they believe must naturally be building up because of this stimulus. Yet, very few commentators have discussed the consequential little worm that is destroying capitalism, and the mindset thus birthed.

Costs of Capital

Generations of business schools have taught — and business leaders have implemented — capital budgeting philosophies based on expected rates of returns and weighted average cost of capital (WACC). First, cash flows over a time horizon are estimated for a proposed project. On the positive cash-flow side, these may include additional revenues created or future expenses saved. Either way, there is some benefit to a business of the proposed project. Netted against these benefits are the negative cash flows — the expenses — that are expected to be incurred to implement the project. Next, the net flows over time are discounted by the WACC,  and the assumed risks of successfully implementing the project are built into this discount rate. If the net present value (NPV) of this calculation is positive, then businesses are supposed to proceed with the project. Still, others prefer to compare their expectations for internal rate of return (IRR) to the WACC. Either way, the process is the same.

The Little Worm

But this entire framework has a problem — the little worm that is destroying capitalism, albeit slowly. Namely, in calculating cost of debt and cost of equity for businesses, market-based rates are used, and with the misnamed “risk-free rate” serving as the root of all other costs of capital. What happens though when central banks’ loose monetary policy creates too much capital and artificially holds down root costs of capital? Companies adjust their required rates of return down, too. In fact, one could argue that this is a principal reason for why central banks are holding root costs of capital so low: to spur business investment.

Yet when WACC is held artificially low, many projects are accepted that previously would never have been considered viable under normal circumstances. Put another way, the problem is using relative values — not absolute values — in calculating costs of capital. Examples of such projects providing marginal benefits are: improving financial reporting systems through better information technology, minor tweaks to supply chain logistics, cutting back on marketing or increasing low-cost advertising (like social media), “rationalization” of head count, holding average wages as low as possible, squeezing suppliers a little bit, not repatriating earnings to stave off taxation, refinancing rather than retiring debts, and the share buyback that is insensitive to a company’s current stock price. I could go on.

It is not that these marginal WACC projects are unworthy and shouldn’t be done, it is that the lifeblood of capitalism is creative destruction. It is fiery and intense. Capitalism is supposed to be more like a volcano than a hot plate keeping the coffee warm!

Evidence that the worm is eating away at capitalism is that revenues continue to grow much more slowly than do earnings per share (EPS). Furthermore, revenues continue to miss consensus estimates even though EPS continue to beat estimates. Also, EPS continue to grow so quickly due mostly to a shrinking denominator (i.e., big share buybacks). Ask yourself: When was the last time you heard genuine risk-taking behavior on the part of your portfolio of businesses? I think you will agree that only a handful of companies are engaged in proper game-changing capitalistic risk taking.

Normalized Cost of Capital

In the developed nations, I estimate a normalized long-term project after-tax WACC of around 6.5%, versus an estimated late 2014 WACC of only 3.0%. Even if you disagree with my estimates, I believe if you calculate your own, you will find that current costs of capital are about less than half of a normalized figure. That means you should expect at least 100% more projects being approved than under normal cost of capital scenarios. Yet this high figure may actually understate the number of excess projects being funded. This is because as cost of capital asymptotically approaches zero (i.e., “to negative nominal yields and beyond!”), the actual number of projects thought of as viable may follow a power law distribution instead of behaving linearly. In other words, businesses are currently in the process of destroying what was, once upon a time, a precious resource to be conserved: capital.

A Remedy?

If you agree with me, I propose, as a simple remedy, that costs of capital for a business begin to be evaluated on an absolute, normalized basis, rather than on a relative basis. And, I would add, treating externalities as free/not considering economic, social, and governance (ESG) is not going to cut it either. As a shareholder — or prospective shareholder — you do not need to wait for a company to engage in this behavior. Instead, you can begin to use normalized costs of capital in your own estimates of fair value. This may shrink your universe of investible assets, so be wary of diversification being worse.

Fear the Worm

My big fear is that even once costs of capital begin to rise/normalize, a generation of gutless business leaders is being hatched in the current gutless business culture. In short, artificially low costs of capital are eroding the capitalist’s risk-taking, return-generating mindset. Yikes! In conclusion, which company would you rather invest in: the one using normalized costs of capital in capital budgeting, or the company just using traditional methods? Thought so!

Image credit: ©iStockphoto.com/afe207

Originally published on CFA Institute’s  Enterprising Investor.