The current economic environment demands that business leaders rethink their strategy in light of rising interest rates and a normalized cost of capital. While last year’s unexpected rate hikes left many executives and investors scrambling, today’s levels—although higher than the ultra-low rates of the past decade—offer an opportunity to recalibrate your strategy and harness the power of economic profit.
Understanding the New Economic Landscape
Businesses are no strangers to fluctuating capital costs, but the recent surge in interest rates has brought these challenges into sharp focus. When we surveyed over 3,100 executives, interest rates and inflation emerged as the top disruptors, outranking concerns like politics, regulation, AI, and even climate change. The reality is that while the cost of capital has returned to what many consider normal levels, these costs are now an integral factor in every decision from budgeting to long-term strategic planning.
Rather than viewing higher interest rates as an obstacle, forward-thinking companies see them as a catalyst for disciplined financial management. With capital costs at normal levels, there’s a renewed imperative to ensure that every dollar invested generates a return that exceeds not only operating expenses but also the cost of capital itself. This is where the concept of economic profit (EP) becomes critical—EP is defined as the revenue generated minus operating and administrative expenses, further reduced by the cost of the capital required to produce that revenue. By adopting an economic profit mindset, companies can pinpoint where value is truly being created and where capital is being squandered.
Integrating the Cost of Capital into Your Strategy
Incorporating the cost of capital into strategic decision-making isn’t just prudent—it’s transformative. Companies that integrate this discipline have a distinct advantage. With a focus on economic profit, businesses can reallocate resources to high-return projects and avoid investments that may appear profitable on the income statement but fail to cover the true cost of capital. For instance, rigorous analysis often reveals that in large corporations, less than 40% of the capital employed generates more than 100% of shareholder value, while 25-35% actually destroys value. This level of granular insight into capital efficiency is the key to unlocking superior returns.
To put it simply, if your company earns a 15% return on equity, pays 3% to shareholders, and reinvests 12%, you can compound that growth over just six years to generate more equity than initially existed. This reinvestment advantage—the ability to invest more productively than competitors—becomes a powerful driver for long-term success. Companies that have embraced this approach have delivered shareholder returns that exceed industry peer averages by more than 50%.
Adopting such a strategy means transforming your business planning process. Instead of relying solely on traditional income-statement forecasting, you must measure economic profit at every level—by product, customer, channel, and business unit. This approach not only helps in better allocation of capital but also serves as a strategic guide, indicating which areas of the business offer the greatest potential for margin improvement and sustainable growth.
Driving Long-Term Growth with Economic Profit
The benefits of integrating cost of capital into your strategy extend far beyond simple budgeting adjustments. When companies consistently manage economic profit, they gain a competitive edge that cascades throughout the organization. By clearly identifying where profit is created—and where capital costs outweigh earnings—executives can direct investments to areas that yield the highest returns, while cutting back on initiatives that drain resources.
For example, a major brewer’s analysis revealed that the bulk of its economic profit growth was concentrated in just a few key channels and product lines. Armed with that insight, managers were able to redirect commercial efforts and investment toward those high-impact areas, outspending competitors in markets that truly mattered. This strategic reallocation not only boosts immediate profitability but also sets the stage for sustainable, long-term growth.
Moreover, a refined focus on economic profit encourages smarter growth strategies during acquisitions and capital budgeting decisions. When evaluating potential mergers, companies can use economic profit as a critical metric to determine if an acquisition will create value or simply add to the cost of capital burden. Similarly, by aligning compensation and incentives with economic profit targets, organizations ensure that every management decision is made with an eye toward maximizing shareholder value.
In conclusion, adapting your strategy to higher interest rates is not about retreating in the face of increased capital costs—it’s about harnessing those costs to drive a more disciplined, strategic approach to business. By integrating the cost of capital into every facet of your planning and operations, you can unlock significant competitive advantages and ensure that every investment contributes to long-term growth and sustainable profitability.
