Quo vadis capital costs?

The importance of capital structure and capital costs for strategic management control

Stern Stewart & CO. GmbH
Salvatorplatz 4
80333 Munich

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An economic boom, abundant cash flows, and ample liquidity are usually triggers for investment and growth. Acquiring “cheap” outside capital also appears to be much easier once again. And finally, return on equity can be further boosted by means of special dividends and share buybacks. But what would be the price of such actions?

Whether it is due to after-effects from the last crisis or sober-minded strategizing for the future, many CEOs and CFOs are clearly cautious at present, and are barely taking full advantage of their regained financial options. Some are even going so far as to even now pay back more of their outside capital and increase their equity ratio. The reason for this restraint must be the expectation of many company directors that capital could soon once again become something that is hard to come by, and that has more strategic relevance than ever. However, conventional wisdom tells us that this increase in the equity ratio must inevitably lead to an increase in capital costs. Or perhaps not?

The answer to this question will be critical to the financial management of the company, both for the financing and for the internal allocation of the capital. The following key observations will need to be taken into account:

1. Capital will soon become scarce and expensive once again

2. The standard weighted average cost of capital is not suitable for optimal management

3. The risk and the term of the assets determine the capital costs

4. Management of the portfolio calls for the provision of differentiated and dynamic capital costs

5. The capital structure is optimized allowing for the greatest possible strategic flexibility

CEOs and CFOs should take advantage of the present quiet phase on the capital markets to develop a comprehensive understanding of the specific and risk-adjusted capital costs of their business activities and of individual assets. It may not yet be obvious right now what benefits this will afford, but those who set themselves on the right path now will certainly reap the benefits in the next capital shortage phase.

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