Page 109 - Five Forces of Americanisation Richard Hooke 04072025 final post SDR1

The UK Defence Industry in the 21 Century
st
The Five Forces of Americanisation

Appendix 5

Leverage as competitive advantage: calculating the cost of capital
The cost of capital is the rate of return required by investors to compensate them for the risks they undertake
by investing in a business. It is used as the rate at which future free cash flows can be discounted in order to
express their present value. If predicted cash flows are considered reasonably accurate or reliable, then this will
indicate the probable corporate value of a business.
The actual hurdle rate used to assess investment opportunities may be slightly higher in order to mitigate the
effects of any forecasting error or uncertainty. Hence it follows that businesses operating in markets enjoying
regular, assured cash flows (like utilities or many public services) offer investors greater accuracy in using
discounted cash flow (“DCF”) as a method for calculating value. The need to define “free cash flow” reflects the
significance of cost control as a management attribute as well as the quality of a company’s decision-making
regarding the allocation of capital to sustain or improve business efficiency and effectiveness.
Companies are generally financed by a combination of equity (ie: shares) and debt, both of which can be valued
and traded in financial markets. Consequently, the cost of financing a company’s activities can be expressed as
the combined cost of its equity and its debt. These can be weighted by their market values and summarised as
a percentage of total capital. This is known as its Weighted Average Cost of Capital (“WACC”). Businesses that
do not achieve a return on the cost of the capital invested in their company are held to destroy value.
The WACC is a function of:
1. Cost of equity
2. Cost of debt (post tax)
3. Gearing (ie: the ratio of debt to equity

1. The cost of equity reflects the true cost of ownership, encompassing the risks of both failure and
success. Unlike debt, the company’s shareholders (its owners) will only receive a return if the company
is able first to satisfy the needs of its debtors, usually defined by a rate of interest or “coupon”. The cost
of equity is therefore estimated using a formula - the Capital Asset Pricing Model (“CAPM”) – that takes
account of the “risk-free” market rate associated with acquiring capital plus an assessment of the level
of specific risk associated with the company’s activities, adjusted by a factor that reflects the volatility
or stability of the environment within which the company operates. This is expressed in the following
formula:
Cost of Equity = Risk free rate + Beta x Equity risk premium
A hypothetical example is as follows:
Eg: US Defco
10.4% = 4.35%* + (1.10** x 5.5***)

*The Risk free rate is the yield on a ten-year US Treasury bond
**The Beta of an equity or security measures the volatility of its returns relative to the returns on the
equity market overall. It measures only systematic (or market) risk as investors can eliminate company
specific risks by diversifying their portfolios. Beta factors for publicly traded companies can be obtained
from a number of sources such as Bloomberg and Datastream, which calculate the beta from historical
data. However, the beta may also be used to measure the risk profile of a security over the forecast
period. A beta of 1.0 indicates that the stock’s volatility matches that of the relevant equity market in
general.
DefCo’s assumed beta is 1.10, reflecting the relative stability of its market segment
*** The average US market risk premium from 2011-2023
(A note of caution: at the start of 2025, US trade policy has increased the volatility of all market data
worldwide. The above data points should be treated as hypothetical)

2. The cost of debt is less than the cost of equity. It needs to be repaid, either in full at the end of its term
(tenor) or at predetermined intervals on a regular basis. Business school students would recognise the
received wisdom that long term money is for long term investment, debt is short term. However, debt

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