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The Cost of Capital

General Electric has long been recognized as one of the world’s best-managed

companies, and it has rewarded its shareholders with outstanding returns. During its

corporate life, GE has raised a cumulative $76 billion in capital from its investors, but

it has turned that $76 billion investment into a company worth more than $543 billion.

Its Market Value Added (MVA), the difference between its market value and the capi-

tal investors put up, is a whopping $467 billion! Not surprisingly, GE is always at or

near the top of all companies in MVA.

When investors provide a corporation with funding, they expect the company

to generate an appropriate return on those funds. From the company’s perspective,

the investors’ expected return is a cost of using the funds, and it is called the cost of

capital. A variety of factors influence a firm’s cost of capital. Some, such as the level of

interest rates, state and federal tax policies, and the regulatory environment, are out-

side the firm’s control. However, the degree of risk in the projects it undertakes and

the types of funds it raises are under the company’s control, and both have a profound

effect on its cost of capital.

GE’s overall cost of capital has been estimated to be about 12.5 percent. There-

fore, to satisfy its investors, GE must generate a return on an average project of at

least 12.5 percent. Some of GE’s projects are “home grown” in the sense that the

company has developed a new product or entered a new geographic market. For ex-

ample, GE’s aircraft engine division won more than 50 percent of the world’s engine

orders for airline passenger jets, and its appliance division recently introduced the Ad-

vantium speedcooking oven and the ultra-quiet Triton dishwasher. GE began Lexan®

polycarbonate production at a new plastics plant in Cartagena, Spain, and GE Capital

expanded in Japan by creating a new life insurance company. Sometimes GE creates

completely new lines of business, such as its recent entry into e-commerce. In fact, GE

was named “E-Business of the Year” in 2000 by InternetWeek magazine. When GE

evaluates potential projects such as these, it must determine whether the return on

the capital invested in the project exceeds the cost of that capital.

GE also invests by acquiring other companies. In recent years, GE has spent bil-

lions annually to acquire hundreds of companies. For example, GE recently acquired

Marquette Medical Systems, Stewart & Stevenson's gas turbine division, and Phoenix-

cor’s commercial equipment leasing portfolio. GE must estimate its expected return

on capital, and the cost of capital, for each of these acquisitions, and then make the

investment only if the return is greater than the cost.

How has GE done with its investments? It has produced a return on capital of

17.2 percent, well above its 12.5 percent estimated cost of capital. With such a large

differential, it is no wonder that GE has created a great deal of value for its investors.

Sources:Various issues of Fortune;the General Electric web site, http://www.ge.com; and the Stern Stewart & Co.

web site, http://www.sternstewart.com.

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