Innovations in Control: Do you have the right cost of capital for today's environment?

This post is co-author Joseph Calandro, Jr., author of Applied Value Investing (NY: McGraw-Hill, 2009). One of the most important and overlooked innovations in business are the innovations in internal controls and measurement.  The duPont company famously invented their duPont formula which helped their executives to understand exactly what was driving financial performance in their business; which divisions were making good margins; which consuming too much capital.

We think that the story of the 1980s-2008 was a story of focus on the external financial innovations -- which were significant both in their market impact, and on their forms of corporate governance.  For example,  in the 1960s and 1970s many conglomerates formed to give shareholders a promise of diversification.  But with the three innovations of the efficient market hypothesis, mutual funds, and corporate commercial paper, many investors asked themselves, why should they own  a holding company when you can efficiently hold each of the "divisions" directly?  Financial innovation and theory had a direct impact on corporate governance and organization form.   And despite the havoc that complex financial instruments have wreaked on our worldwide financial system, few observers would claim that they are all bad.  Remember that in recent years Southwest Airlines helped to create tremendous value for their shareholders by effectively hedging fuel costs, just to name one company.

Given increased volatility and continued financial uncertainty, our question is what "internal" message should firms take from the recent financial innovations and their devastating impact on many banks and markets.  We believe that firms need to  reexamine their risk models and to inspect their evaluation and feedback loops those models depend upon.  Put another way, you want to make sure that there are no simplifying assumptions that created so much havoc for mortgage-backed securities.  You want to make sure your control systems accurately reflect the current risk.  More specifically, we think that in such a volatile market, senior executives should look anew at their corporate hurdle rate, and think about "de-averaging" that rate.  We have performed extensive analyses of financial services companies and found that they have an overly simple hurdle rate.  This means that when a management team assesses a portfolio of projects, they are not comparing apples to apples.  When a new, de-averaged hurdle rate is applied, the senior team usually comes to new operating decisions because they see the real risk/return of their business in the current environment.

In addition to the new differentiated hurdle rate, such an analysis can also lead to adjustments in capital structure, in which the financial team, with the senior executive, can begin to match forms of capital to the nature of the operational and market risk.   For example, mature cash generating initiatives can be matched to debt while newer more entrepreneurial initiatives would be matched to equity. In short, matching of the balance sheet to the nature of the business risk help to make risk management tangible.  Of course there won't always be a one to one risk match, but such an exercise can show the team just how close their capital structure reflects their operating reality.  Together,  "de-averaging"  and funding matching, facilitate a much more strategic view of the "cost of capital," especially when that information is aligned with performance management.

The skill set needed to implement this kind of approach involves elements of science (or knowledge of the theories underlying conventional business practice), art (experiential-based learning and insights), and behaviorial understanding (knowing how to operate effectively in external and internal environments). Such a skill set is relatively rare; however, those who possess it should be able to make the most out of their current returns to capital and be better prepared to weather markets in times of calm and turbulence.

We don't expect the markets to calm down any time soon, so now is the time to build up your organizations ability to operate in more informed way.

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