Sunday, October 22, 2006
Cost of capital
To an investor, what is the cost of capital and how is it measured? These are two very basic questions that an investor must ask themselves and understand what it means to them in order to allocate one’s capital in the most optimal manner that one can manage to.
I suggest you to think about it before reading on and then see how much the following differs from yours. Could capital cost mean the interest rate paid by the business or any additional cost associated with raising the capital? Could it be the cost of borrowing? Interest expense?
First of all, all the above are incorrect and to be able to understand the cost of capital to an investor, the basic meaning of certain facts must be clearly defined. In fact, to a business, bank loans, interest, bonds issued, etc., are not a cost to the capital or shareholder's equity or constitute as part of the shareholder's equity. Strictly speaking, capital of a business refers to the shareholder's equity. If you know your financial interpretation well enough, shareholder's equity is the net residue amount available to the common stock shareholders after deducting all liabilities. In fact, such cost to the business should be classified as cost of loans, not capital. To make sense of this, ask yourself a question: "Does a business pay cost of borrowing from the shareholder's equity?" The only business that pays from shareholder's equity is those who are losing money, i.e. they have to eat into the shareholder's equity. So if a company is making money, it too means they are increasing shareholder's equity, so how can that be a cost to the capital (shareholder's equity)? Then again, the net income has already accounted for all kind of expenses used in the course of business. So if it is accounted for, to account it again as a cost of capital, it is double counting.
An investor must be able to distinguish the cost of capital for the business from the cost of capital for themselves. The theory running the cost of capital is the same from the business side as well as the investor side. Essentially, it is an opportunity cost of the capital which is retain in the business and if it can generate better returns compared to an alternative means.
To an investor in a business, capital is all about what is invested today to churn out more for the future. Thus, cost of capital means the ability of a business to create more than a dollar of value for every dollar invested or earnings that are retained. Of course this alone does not determine if the cost of capital will be to an investor's advantage or not. Then you have to think if a dollar is worth more in your hands, or if retaining in the business will produce more than in your hands. It means if the business retains a dollar of profit, they must be able to churn out more than what it can as if it is in your hands. So if you can churn out at a rate better than the business, the company would have failed you.
Many investors literally mistake the interest rates of the loans of a business as the cost of capital, where in fact, it is the cost of loan. By further questioning the nature of this, such cost of loan is in fact factored in when you get your earnings reported at the end of the fiscal year. Ultimately, as an investor, these earnings are used to calculate your return on equity. So by considering the cost of loans as your cost of capital is flawed. This should be discounted and you must be able to roughly determine what you can produce versus what the business can produce. If the business produces less than what you can produce if the capital is in your hand, you could have done better than them.
This may be intangible but it is important for an investor to grasp the meaning. To an investor, the cost of capital is the cost of lost opportunities if the company performs worst than you. If they perform better than you, there is no cost of capital. And I think an excellent and fair management should view it from an investor point of view whereby they do not hold investors back from what they can actually perform.
You may mentally argue that this is so intangible. But if you are looking for something tangible to compare, one of the tangibles is the risk-free interest rate. At minimal, a business must outperform the returns of the current risk-free interest rate. If a business cannot outperform the return of a risk-free interest rate investment, what sense does it makes for one to work so hard when you have an alternative where you can do nothing but “shaking legs” while you can earn just as much as working so hard?