What is Cost of Capital – Properly Considered

Cost of capital is the concept that a real cost exists for the use of every source of a company’s funds.

As an manager or investor, I want to use the funds I have available to me as efficiently as possible. I know as a basic economic concept that there is no such thing as a free lunch. Borrowing money has a cost in the form of interest and issuing equity has a cost as well. No where can I find a truly ‘free’ use of my capital.

Therefore, when I put my dollars into an investment or project I want to earn a rate of return above those combined costs.

My cost of capital is simply the cost of using those available sources when investing. As an investor or lender providing those funds, it is the minimum cost I will charge for you to use those funds.

The expected return on capital has to be higher than the cost of capital for an investment to make practical sense.

Understanding Opportunity Cost Is The Key To Understanding The Cost Of Capital

If I have only 10 dollars to buy groceries at the store, my total option set is limited by that ten dollars. Opportunity costs are those things I had the money to purchase but did not.

In a business context, the funds available to the business in the form of cash on hand, debt and equity can be thought of as the money in hand when shopping among available investments.

I like to think of investments food in a giant grocery store. Instead of comparing the calories of a banana to a steak, I am comparing various investment alternatives and their relative rates of return.

When shopping for my wife’s favorite canned cranberry jelly I am shopping for the best outcome at the best price. I don’t like taking risk with my canned cranberry (who does) . I will automatically reject any open or damaged or expired cans. I want a cranberry sauce that is going to be risk free, meaning no food poisoning at Thanksgiving.

Similarly, when I invest, I want the risk profile between options to be as equal as possible to make them comparable. And, all else being equal, I want the cheapest product. Afterall, the only ingredients mentioned on the label is ‘cranberry.’

At the store, my options are a generic store brand product and the branded Ocean Spray product. When I buy store brand I can save .35 cents but my opportunity cost is the Ocean Spray can for .35 cents more.

As a business owner or investor, instead of buying canned fruit, I am really buying a stream of future cashflows. The difference between the investment option I choose and the next best option is my opportunity cost of capital.

What Really Matters When Considering Opportunity Cost And Available Capital For A Business

A firm's cost of capital is influenced by a limited set of factors. The two biggest of those factors are:

1. Opportunity cost created by management – I.E. what other investment options have they created internal and external to the firm.
   
2. Costs to use debt and raise equity - we have established that capital is not free.

Berkshires cost of capital is the best alternative investment for the use of available capital.

‍- Warren Buffett, 2001

The Three Primary Questions To Consider Related To Opportunity Cost

Cost of capital is really just the best alternative investment for the use of available capital. Companies are limited to only five uses for their available capital. The framework for considering what to do with existing capital however is only two questions. 

1. Can you create more than a dollar of present value with a dollar of investment ?
   • IF you can achieve a return for investors by retaining more than a dollar then you simply look around for the thing you feel the surest about and promises the greatest return weighted for that certainty.
     • Weighted for certainty means statistical outcome. (discussed below)
   • All firms should measure cost of capital by creating more than a dollar for each dollar retained.
     
2. If the answer to the above is Yes - How do you create the most value with the least risk?
   • All firms should measure cost of capital by creating more than a dollar for each dollar retained.
   • A tool like the risk free rate should form a common yardstick for all investment options considered. Risk, does not equal volatility but instead the loss of the investment.
     
3. If the answer to the above is No - Pay out to shareholders ( dividends or repurchase shares)
   • It is better to return capital to shareholders when you cannot create more than a dollar of value by reinvesting it internally or externally.

Other Helpful Definitions Related To The Cost Of Capital

Marginal Cost of Capital – is the cost to raise one additional dollar of new capital from each source of capital.

Implicit Cost of Capital –  often referred to as imputed, implied or notional cost is the cost of using an existing asset you don’t rent from someone or rent out to other people. It can also be thought of as the time and effort a business owner puts into maintaining an existing company rather than growing it.

Explicit Cost of Capital – Payments made to resources such as land labor or capital (machines or buildings).

A simple analogy to remember these definitions is think of yourself as starting restaurant that makes and sells high end pizzas. You have explicit costs that go into buying an oven, ingredients and hiring any staff. You don’t intend to operate the business yourself, but face an implicit cost of maintaining the books and stepping in to help resolve any serious issues that occasionally pop up.

In a few years you may want to raise capital to expand into some neighboring cities. You can easily raise a million dollars from friends, family and local acquaintances. But if you want capital above that amount it will cost you more than a few stamps and cheap pizza to raise the money. This the marginal cost of capital. At the end of the day, these are all just different terms for opportunity cost.

The Most Common Misconception Related To Cost Of Capital And Opportunity Cost

Face value, thinking about what the costs to use sources of funds are important.

I don’t want to lay out money today with just the promise of a return and not actually achieve that return. If the project goes belly up there is a dual cost that will be assumed by the business and the investors. The dual cost is the forgone value creation that will never materialize and the added cost of any new debt and equity obligations.

And here in lies the problem. Investors and managers don’t typically plan for projects to fail. They should. Even the best baseball players will strike out now and again and it is likely that business projects will sometimes fail to materialize returns. Of course, that is precisely what will happen. Investments don’t always pan out as planned. Unforeseen events often disrupt otherwise steady returns. 

Imagine a business investment where all an investor needs to do is flip a coin. The investment has a 50/50 probability of resulting in a loss or a gain. Each gain is million dollars and each loss is a million dollars. The net result of repeated coin flipping is not actually a neutral result. Instead, it is a negative result because of the opportunity cost of distributing the money or putting it to better use elsewhere. In a market scenario you would also be charged a fee to flip the coin.

Now imagine tossing the same coin but you have 75% chance of winning. Assume the frictional costs exist but are still are manageable. Is the result of a loss still bearable? How many times do you need to win to make up for a losses?

If you cannot answer this question then you cannot know that the cost of capital calculation used for an investment justifies the investment in the first place. For a an investment to be appropriate a firm must be able to make investments that will produce an adequate return AND account for eventual losses.

It is a complete misconception that a cost of capital equation alone justifies an investment. An strong implied return from an investment can always be satisfactory in its own right. But the aggregate result from similar bets needs to pay off with a similar probability, not just the individual bet being placed. Cost of capital calculations do not in and of themselves account for failure risk. Management should.

Human nature is such that management can and will trick themselves and others into showing workable numbers for a prospective investment. Giving no consideration to the statistical probability of the undertaking or future endeavors is common.

A cost of capital calculation should consider the statistical likelihood of the outcome. An investment may have the potential for a very high rate of return. Opportunity cost for an investment should consider the statistical likelihood of the outcome. The probability for loss must be considered along with the probability of a successful outcome.

In the next section, we will discuss how Beta is often used as a proxy for this risk and how it falls short.

How Beta Traditionally Factors Into Costs Of Capital And Why Using It Can Inject Irrational Data points Into Decision Making (Hint: The Academics Get It Wrong)

The beta calculation is used to help investors understand whether a stock moves in the same direction as the rest of the market. It also provides insights about how volatile–or how risky–a stock is relative to the rest of the market.

- Investopedia.com

Put as simply as possible, beta is an academic tool used to calculate a component of the equity cost of capital. Some of the biggest businesses have grown without this caulculation:

Warren Buffet: Charlie and I don't know our cost of capital. It's taught a business schools, but we're skeptical. We just look to do the most intelligent thing we can with the capital that we have. We measure everything against our alternatives. I've never seen a cost of capital calculation that made sense to me. Have you Charlie?
Charlie Munger: Never. If you take the best text in economics by Mankiw, he says intelligent people make decisions based on opportunity costs -- in other words, it's your alternatives that matter. That's how we make all of our decisions. The rest of the world has gone off on some kick -- there's even a cost of equity capital. A perfectly amazing mental malfunction.

‍- BRK Annual Meeting 2003

Beta, used in the academic calculation of equity cost of capital the CAPM to determine volatility of a share price. Volatility in this case, is just the change in the stock’s price up or down. Beta does not measure any shift in the real underlying value of a business.

Beyond the issues already mentioned - beta has a lot of flaws as a measure. Here are a few additional points:

• The beta calculation cannot assume bankruptcy or loss of capital as an option.
• Clearly an investment using equity as a component should materially exceeded any risk threshold and include a margin of safety.
• A stock is not ‘more risky’ because its price happens to be lower. The opposite can be true.

If you shop put an offer on a house for 100k and the seller decides to drops the price down to 75k the day after you place your bid. Assuming there is nothing wrong with the house is your risk increasing or decreasing? Beta works the opposite way.

Confused Yet?

The simple answer is that investors and managers should avoid any prescriptive mathematical formula for costs of capital. Anything too precise is bound to be inaccurate. False precision should be avoided in decision making. The opportunity cost you create, which consists of probabilistic outcomes, will determine your ability to deploy capital favorably.

To briefly summarize what you should do when you have capital:

Step 1 - Ask the following question

Is it better to keep the capital or return it to shareholders?

When you cannot you cannot create more than a dollar of value with that capital it is best to return it to shareholders.

Step 2 – If the answer to the first question is no then ask the second question

How can I achieve more than a dollar of value for every dollar retained?

Step 3 – Expand opportunity cost

Look around for the thing that you feel the surest about

Step 4 – Determine probability of each opportunity

Choose the investment that promises the greatest return weighted for that certainty.

Step 5 – Act

“ … Our cost of capital is, in effect, is measured by the ability to create more than a dollar of value for every dollar retained. If we’re keeping dollar bills that are worth more in your hands than in our hands, then we’ve exceeded the cost of capital, as far as I’m concerned.
And once we think we can do that, then the question is, is how do we do it to the best of our ability? And frankly, all the stuff I see in business schools — and I’ve not found any way to improve on that formula.”

‍- Warren Buffett

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