Evaluation of Capital Cost: Long Run Evidence from Manufacturing Sector

Abstract

The article is directed to determine the most appropriate method for evaluating cost of capital of a manufacturing sector and, using the methodology, to perform a case study of Lithuanian manufacturing sector. For evaluation of cost of capital, calculation of Weighted Average Capital Cost was chosen, as literature analysis distinguished this method as the most widely accepted and used. Some changes were made to the methodology of WACC evaluation in order to adapt the method for countries, which do not contain liquid, mature financial markets, like using country’s credit ranking to assess risk premium and adding this premium to base premium for maturelly developed equity markets. The case study of Lithuanian manufacturing sector was performed for the period of 2001-2016. Empirical study revealed that required rate of return on separate WACC components evolved differently between the years of 2001-2016. Average annual return on equity for the period 2001-2016 was 7.7%, while average annual return on debt was only 4.4%. In the year of 2015 weight of equity capital, first time during the analyzed period, exceeded 50%. In the same year, ratio of net profit before taxes to total assets of Lithuanian manufacturing sector also reached the highest value at the time, later surpassed in 2016. This fact demonstrates, that increased free cash flows from the operations were reinvested into further development of the companies. To maximize value of the shareholders, it would be preferable to pay out portion of earnings as dividends and finance growth with debt, as it is currently a cheaper alternative.