The Fallacy of Cost of Capital

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The Fallacy of Cost of Capital in the Life & Annuity Industry

 

As a longtime business leader with GE, American Express and Ameriprise Financial, I came to expect the inevitability of cost of capital in annual planning and product development conversations. While the number generally had little discernible relationship with the true borrowing cost for the corporate parent, the construct made perfect sense: each P&L bears a reasonable cost for the invested capital carried on its balance sheet. As an independent advisor, I have come to realize that often times this cost is more implicit than explicit. Cost of capital appears most often in the guise of a hurdle rate. Whether considering new product design or a major technology investment, running a spreadsheet against the hurdle rate is a prerequisite. Once implemented, though, how does the cost of capital manifest itself in business unit financials? In an annuity or life business level P&L, for example, where significant issuance costs are capitalized and amortized; is the business charged a carrying cost at the cost of capital? Is there a journal entry from the parent, ultimately eliminated, mind you, reflecting the opportunity cost of this investment? Often not, which stifles creativity and confounds analysis of alternative capital structures. The parent is happy with a nominal 10% or 12% or 15% return. Have they accounted for the true cost? As businesses firm up the 2015 planning cycle, perhaps it is time to reflect on the efficacy of cost of capital execution and the downside risk of not fully accounting for the true cost of investment in business units. This recalibration may yield better corporate results by incentivizing scrutiny of invested capital, freeing up capital for long deferred investment projects. Call or email me to discuss this interesting insight and learn how it may inadvertently hamstring your growth.

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