Tell Mike it was only business. I always liked him.
Tessio in The Godfather (1972)
Chances are cost of capital would evoke a different explanation depending on whom you are asking from. It is one of the most ubiquitous tools in finance showing up in almost very dimension of corporate finance, investing and financial decisions and determining financing choices.
But, in its most original form, it is a weighted average of the cost of debt and equity for a business.
The cost of equity reflects the risk that equity investors see in the investment and the cost of debt reflects the risk that lenders perceive in the investment.
But why is cost of capital so misunderstood?
Behind the complex calculation of cost of capital, it is described as
- Opportunity cost | for investors
- Discount rate | for companies
- Hurdle rate | for projects within the companies
These rates differ according to the usage and sometimes suited to manage one’s own definition and risk.
For investors, cost of capital is an opportunity cost as it is the rate of return that they would expect to make in other investments of similar risk. An investment is called a good investment if the returns are much larger than the cost of capital.
For companies, it becomes a cost of financing which can be again through debt or equity.
Finally, within the companies, it can morph into hurdle rate on investments, where the cost of capital is different for each investments depending on the risk profile.
A good cost of capital is an optimising tool to reduce the cost of funding as much as possible. Companies use cost of capital to take the right mix of debt and equity to keep the cost of funding as low as possible.
For a private company, the cost of capital is generally higher to reflect company specific risks since the owner will be not diversified.
One of the ways in which it is mis-used is by using it as a mechanism for reverse engineering a pre-determined value. This often leads to no justification and has the potential to create bad blood.
Image credits: Alexander Andrews on Unsplash