Creating Value When Capital Is No Longer Cheap

Creating Value When Capital Is No Longer Cheap

Over the past decade, executives enjoyed historically low borrowing costs. Central banks kept nominal rates near record lows, and capital flowed freely into corporate projects and financial engineering alike. Yet this era of cheap money—now widely regarded as an anomaly in modern financial history—has ended. Nominal interest rates have reverted toward long term historical averages after being suppressed for nearly two decades; indeed, average nominal rates over the past 150 years have been closer to 4.9%, well above the 2% era most corporations grew accustomed to.

When capital was cheap, growth strategies often trumped disciplined investment decisions. But in a world where capital must earn its keep, firms face a strategic inflection point: value creation now hinges on fundamentally rethinking how they allocate and deploy capital—not simply how much capital they can access (see also Capital Allocation and Value Creation).

The Strategic Challenge: Cost of Capital as Strategic Filter

From Cheap Growth to Disciplined Allocation

The rise in interest rates increases the weighted average cost of capital (WACC) for firms across industries. WACC—the blended cost of equity and debt—functions as a hurdle rate for investment decisions: only projects yielding returns above WACC generate economic value.

When capital was cheap, many companies pursued investments with marginal or negative economic returns under the assumption that future growth or revenue expansion would compensate. In contrast, high capital costs demand rigorous scrutiny: firms must sharply differentiate investments that deliver true surplus value from those that merely increase scale. A strategic shift toward economic profit discipline—measuring revenue minus the full cost of capital—can materially shift outcomes. Surveys show teams that integrate this discipline drive shareholder returns well above industry peers.

Portfolio Focus: Reallocate to Winners

Research by BCG shows that in the current high rate era, roughly half of nonfinancial companies in the S&P 1500 earn returns below their current cost of capital—a stark metric of misplaced capital deployment.

Executives must therefore reassess portfolios ruthlessly:

• Retain and invest in high ROIC (Return on Invested Capital) businesses
• Divest marginal units that fail to cover cost of capital
• Redirect capital to segments with structural advantages

This shift revisits classic portfolio management principles pioneered decades ago—but with renewed urgency when capital is no longer free (related: Business Strategy).

Real World Corporate Responses

1. Walmart: Omnichannel Transformation

Walmart’s aggressive investment in omnichannel capabilities illustrates strategic capital allocation in a higher cost environment. Recognising that future retail growth would be driven by digital physical integration, Walmart committed over $5 billion annually to e commerce and supply chain improvements, even at the expense of short term profitability. This capital repositioning was guided by understanding where long term returns would exceed the cost of capital and position Walmart against digital natives (see Digital Transformation).

Key lessons include:

• Prioritise initiatives with sustainable competitive advantages
• Accept short term earnings hits to build long term value
• Be willing to shrink legacy businesses where they underperform

2. Costco vs. Brown Forman: Different Paths, Same Value

Costco and Brown Forman illustrate that high returns on capital—not merely high growth—drive enduring shareholder value. From 1996 to 2017, Costco’s after tax profits grew faster than Brown Forman’s, yet both delivered roughly 15% annual shareholder returns because Brown Forman’s returns on capital significantly outpaced Costco’s.

This underscores a vital point: growth alone does not guarantee value when the cost of capital is high. Instead, firms that sustain robust returns relative to their cost of capital tend to outperform.

3. Private Markets: Rethinking Value Creation

Private markets and private equity (PE) firms, long dependent on leverage to amplify returns, are recalibrating. Higher borrowing costs mean traditional leveraged buyouts (LBOs) are less lucrative unless combined with substantive operational improvements. PE firms increasingly emphasise operational value creation over financial engineering, achieving returns 2–3 percentage points above peers largely through portfolio optimisation and performance improvement.

Strategic Levers for Value Creation in a High Cost Environment

A. Precision Capital Allocation

Capital must be directed toward activities that outperform the cost of capital. High return on invested capital (ROIC) becomes the strategic North Star. Classic projects—such as incremental expansion in mature markets—fall by the wayside unless they clear the economic profit hurdle.

B. Operational Excellence

Value creation shifts toward operational improvements:

• Lean processes
• Digitisation
• Supply chain resilience

Firms that optimise internal operations preserve cash flow and elevate returns on existing assets, making them more resilient when external capital is expensive (see Operations Management).

C. Innovation and Long Term Investment

Innovation remains critical—even when capital is costly. But now the bar is higher: investments must promise differentiated capabilities or structural advantages. Firms that innovate in ways that deliver premium pricing or cost leadership can overcome the headwind of expensive capital (related: Innovation).

D. Strategic Divestitures

Underperforming units are liabilities in a high cost capital world. Divestitures free capital for reinvestment in core businesses and sharpen strategic focus. This discipline also enhances overall portfolio returns.

Macro Insights: Capital Cost and Corporate Behaviour

Economists have long observed that when interest rates rise, investment slows and firms revisit financing and investment strategies. Rising rates affect the cost of debt directly and indirectly shape corporate decisions on expansion, capital structure, and risk appetite.

Higher capital costs also shift investor expectations: valuations increasingly reflect underlying corporate fundamentals rather than financial engineering. In this environment, firms that generate real economic value distinguish themselves, while “zombie” firms that rely on cheap capital risk insolvency (see Corporate Governance).

Conclusion: Value Creation Under New Constraints

The era of cheap capital is over. This new normal compels leaders to think strategically about where and how they invest, allocate, and sustain capital. Value creation no longer hinges on access to money but on disciplined deployment—with returns that exceed the cost of capital (see Competitive Advantage).

Boards and C suites must re embed fundamental financial discipline:

• Economic profit accountability
• Portfolio prioritisation
• Operational excellence
• Innovation with measurable return

In doing so, companies can not only withstand the constraints of expensive capital but thrive—turning challenge into enduring competitive advantage.

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