There are so many different projects to consider as we plan and build out our resorts. And consider them we must: how we allocate our scarce capital resources can make the difference between building a successful resort and setting back long-term prospects of the business. In order to improve our chances of success, we must understand our cost of capital—the financial return that shareholders and lenders expect to receive when they provide their money to the company—and how to best identify which investments will create long-term shareholder value.


Making Choices
Our employees, guests, suppliers, regulatory agencies, the local community and shareholders all generate ideas on how to invest our company’s scarce capital resources. There are almost always, however, a greater number of project ideas than available capital, so we must prioritize these investments. We need a method to sort out the winning projects from the also-rans.

The money used to fund our ski area projects and our business always has a cost. (If we invest our own cash and our ski-area investment lags behind investments we could have made elsewhere, it has cost us money to invest in our company.) We view our resort as renting money each year, and we had better make the rent payment, and then some, if we are going to enhance shareholder value. That’s what creates long-term sustainability. The banking business is one of the best examples of how this works. Banks pay about 3 percent for their money, which they lend to us at a rate of about 7 percent. That is a nice spread between their cost of and return on capital. A quick look at any major bank’s financial statement shows how successfully this creates shareholder value.

Another way to view this is to say that our return on capital must be greater than or equal to our risk-adjusted cost of capital. The more risk we take, the greater our return should be.

So: will that new project pay off? There are several ways to evaluate the proposed investment; at Crystal Mountain, we use the Net Present Value (NPV) approach because it takes into account the time value of money, the scale of the investment, and has a realistic reinvestment rate assumption.


For Example . . .
To evaluate our project options, we first create a Sources and Uses of Funds statement (Table 1, below), which outlines project costs and how they might be funded. Next, we create a project pro-forma financial statement (Table 2, next page), which forecasts the expected revenues, costs and after-tax cash flows.

This pro-forma income statement does not include any financing costs. That is because we evaluate each project on its own merit, independent of how it will be financed. Once the financial viability of the project is determined, a final decision can be made on the best way to raise the necessary capital.

The financing cost is accounted for by using the company’s after-tax Weighted Average Cost of Capital (WACC) to discount the projected after-tax cash flows (that is, account for them in current dollars). This provides a measure for the Net Present Value of the investment opportunity. Because each company uses a different mix of debt and equity capital, it makes sense to use a weighted average cost of these two components when computing a resort’s overall cost of capital.

The formula for computing the WACC:
WACC = (%debt) * (pre-tax cost of debt%) * (1 - tax rate%) + (%equity) * (cost of equity%)

Here is an example of the formula in action, using a 55%/45% debt/equity mix, a pre-tax cost of debt of 7%, a 40% tax rate, and a cost of equity of 17%:
WACC = .55*.07*(1-.40) + .45*.17 = .0996 = 9.96%

The WACC is the minimum rate of return at which your project adds to shareholder value. It is also the discount rate used in your project’s Net Present Value financial analysis. If the NPV of your project is greater than or equal to zero using this discount rate, it pays for its ongoing cost of capital (think “rent”) and meets your minimum rate of return investment threshold.

Here is an example: If your overall project cost is $2 million, the project life is 10 years, and your WACC is 10 percent, then your project’s incremental after-tax cash flows must be greater than or equal to an average of $200,000 per year when discounted back into present-day dollars. Otherwise, it will not pay for the money your company must invest.

The biggest challenge is to get the financial forecast assumptions right, particularly the revenue streams. Since we already know many of the departmental expense ratios, it is relatively easy to estimate the expected pro-forma costs. Remember, an investment in one aspect of a ski area typically benefits other profit centers, too, so don’t forget to add these other profits to the projected cash flow stream.

Once our pro-forma assumptions have been thoroughly vetted, we can use the WACC as an objective measure to learn if the project creates value, and we can compare each investment proposal against others (see Table 2). In your analysis, it is also helpful to take a look at several different sets of assumptions (a sensitivity analysis) that may include a best, worst and most likely case.


Debt vs. Equity
The capital structure of most companies is made up of two components, debt and equity. Since many of our projects have a long life, we use our long-term average interest rate in determining our cost of debt, not our current borrowing rate.

No matter how we obtain our debt capital, the benefits of debt are: 1) it is almost always cheaper than equity, and 2) the interest cost is deductible for income tax purposes, so our after-tax cost of debt is considerably less than the pre-tax cost.

However, using debt has risks. Equity is a claim on earnings, but absent dividend payments, there are typically no regular payment requirements or guarantees of a specific return on investment. Debt, however, is the right to a fixed payment stream for a fixed amount of time, and amounts to a frequent and regular call on the company’s cash flows. Over-leveraging a company increases the credit default risk, especially during weak business conditions, and can lead to insolvency. There have been several recent examples of this in the ski industry.

Figuring the cost of equity capital is trickier to compute than the cost of debt, as equity carries no explicit cost. But there is a formula to estimate the cost of equity, the “Capital Asset Pricing Model.” It starts with the Risk Free Rate, which is based on the cost of U.S. Government-backed treasury securities, and includes adjustments for risk and market volatility. Many of these adjustments are quite subjective for each investor, and can vary from company to company. Your accountant or financial advisor can help you create a specific formula that best matches your situation.

In order to simplify the cost of equity calculation, another often-used method is an “opportunity cost” rate of return. In other words, compare your potential ski area equity return, adjusted for risk, against other investment opportunities that you might have. You could start with the historical rate of return on the S&P 500, about 11 percent, and add a risk premium of from 5 percent to 10 percent to account for the risks associated with your business. There is no lack of risks to consider in the ski business.

Another decision is to determine the optimal mix of debt and equity capital for your company. Some business owners do not like any debt and that’s just the way it is. Others prefer to take advantage of debt’s lower cost and tax advantages, so long as they can comfortably and consistently cover their debt payments. If you are comfortable with using debt, it is good to plan for a minimum debt coverage ratio—cash flow before debt service divided by debt service—of at least 1.5 to 1. Larger public companies target even higher ratios.


Looking at the Big Picture
Now, lets take it from the micro or project level to a macro or company level. We talked earlier about the shareholder value created for a bank by the spread between its cost of and return on capital. A similar calculation for your business would be to compare your company’s cost of capital (WACC) with your company’s Return on Operating Invested Capital (ROIC). Your ROIC should be greater than or equal to your WACC to meet the same minimum threshold for adding shareholder value.

We’ve already talked about determining the WACC for your company; here’s how to measure ROIC (see tables, right). Basically, it is the overall cash rate of return on operating capital that has already been invested in your company. It is also a great measure of how a company allocates capital.

ROIC = Net Operating Profits After Taxes (NOPAT)
Operating Invested Capital

Again, sounds complicated, but it’s easier than it sounds. Net Operating Profits after taxes (NOPAT) is simply a measure of the cash that operating activities generate. It focuses our attention on the profitability of core operations. As such, it is a better measure than Net Income, which includes non-operating items such as goodwill amortization, investment income, non-recurring costs, tax paid on investment and interest income, interest expense and the tax shield from interest expense. While these are beneficial, it is most important to understand the profitability of the core operations.

Operating Invested Capital represents the combined value of what the shareholders and debt holders have invested in the Company. It is calculated by subtracting cash and cash-equivalents, along with non-interest bearing current liabilities (NIBCLS), from total assets. We exclude cash not yet deployed because it is not yet an Operating Asset. We also subtract the NIBCLS, which include accounts payable, income tax payable, accrued liabilities, etc., because they bear no cost to the company.

Once the ROIC is calculated you subtract the Weighted Average Cost of Capital (WACC). As long as ROIC is greater than the WACC, you are creating shareholder value. If ROIC is less, you are depleting value. Pretty simple, isn’t it?



For Further Reading
For more information on WACC and ROIC, check out “VALUATION Measuring and Managing the Value of Companies,” by Copeland, Koller and Murrin. Other helpful references are “Capital Investment and Financial Decisions” by Levy and Sarnat; and “Creating Shareholder Value” by Alfred Rappaport.