What is the Cost of Capital?

We are talking about the interaction between, corporations and investors in the market, and they need to interact in a market, because investors are the ones that provide the capital, so that the corporations can invest and produce the goods and services that we like to buy. And, that interaction is important, and that’s why we started talking about investors, in sessions one and two. As you will remember we are, thinking a little bit about the way investors think about, other investments and so we talked about, how they evaluate investments in terms of returns. How they evaluate investments in terms of risk, and then we talked about how they form portfolios. And the role of correlation and diversification in those in those portfolios. So, today we’re going to take it from there, and as we said although corporate finances is about the interaction between, corporations and investors in the market. The focus is obviously on corporations. This is not really a portfolio management course, where the focus would be mostly on investors. Here the focus is mostly on corporations. As we said, we cannot really leave investors completely out of the picture. But we are going to focus on corporations, their policies, and what they do. And since we start today and we will talk about. Corporations over the next four sessions of the course we are going to go to the very heart of the corporation. Sessions three and four are actually on the same topic. They are on the topic of the cost of capital, which is one of the most essential variables for any corporation. In fact, some people would argue. That is the most essential variable for any corporation and hopefully by the end of this session and the next, you will understand why, that variable is so incredibly important. So our job in session three, the Cost of Capital is basically to think about, what are the components of the cost of capital. And if you remember the actual title, of this session is The CAPM and the Cost of Capital.

CAPM

The CAPM is a model that we use, to estimate the cost of equity, which is one of the components of the cost of capital. So, basically what we’re going to be doing today in this session is, thinking about,

  • What are the components of the cost of capital?
  • What actually is the cost of capital?
  • And what is the intuition behind, each of the components of that cost of capital?

In Session 4, we are going to be applying, everything that we are going to be discussing in this session. So, as much as we said before that Sessions one and two, run into each other. Sessions three and four also run into each other. So Session three, will look at the intuition and understand, what’s the idea of the cost of capital. And in Session four, we’ll actually calculate the cost of capital, for a particular company, at a particular point in time. All right. So first thing is first. Let me discuss with you a few issues that are important for you to keep in mind. Again, sessions three and four, go together, and these are a few things that you may want to keep in mind throughout both sessions three and four. When we, think about the cost of capital, and we, we actually estimate the cost of capital. First off and we’re going to define what the weighted average cost of capital, that WACC that many people refer to actually is, and we’ll do that in a minute and we’ll do that in three different ways, but first let me just make a few points before we get to that definition and point number one. And this is really important, most people think and actually, you can’t blame people that are not familiar with the cost of capital, that cost is implying that money’s coming out of a corporation. Really, it is just a bad name.

The cost of capital rather gives you the idea that the company is paying, for something, but that is not really what we’re going to calculate. The cost of capital is not really all that much related to cash flows. The cost of capital is really related to risk. That word must be always in the back of your mind. The cost of capital has to do with required returns, and required returns always have to do with the risk that investors feel with the risk that investors perceive when they provide the capital that companies need to make investments. So, point number one and this will become important, when we actually calculate. The cost of capital, keep in mind that this is not so much related to cash flows coming out of the company, as it is related to the risk borne by the investors that provide the capital that corporations need. So those two points are important that the weighted average cost of capital is not really related to Cash flows and that the weighted average cost of capital is actually related to, which is the risk that investors bear when they provide the capital. Now the third point that is important. I like to sort of split between, what I like to call arguable and undisputable issues. And as you see, there are quotes between the word indisputable and those quotes is because in finance there’s nothing really that is undisputable. Now, what do I mean by this? Well, by indisputable, I mean that you know, the vast majority of people, running some of the calculations that we are going to run, would agree. And they should be that these calculations should be run in any given way. As, as you see in finance there are, you know, many ways of doing the same thing, but in some of those things, you know, people actually tend to converge very quickly too, this is right and this is not so right or this is clearly wrong. Well, there are, on the way of calculating the cost of capital some of those indisputable issues, and when we get to some of those, I will let you know that this is. One of those issues, in which the vast majority of people tend to agree, that we should go this way, instead of going in the opposite way. Now, that being said, on the way of calculating our cost of capital, we are also going to find issues that are very arguable. And those issues that very arguably mean, that if you actually look around, at what people do in practice, you’re going to find a very wide dispersion. Now that does not mean that there are no consensus. Sometimes people tend to converge around, this is a better way of doing things than some alternative ways. But it’s not going to be like those undisputable issues. It is not, that just about everybody’s going to go in that direction. Here, you will see people go in, in different directions, with some options more popular than others. All these may sound a little fishy and wishy-washy right now. But you, when we get to those points, I’ll let, I’ll let you know. You know, this is a very arguable issue. Or this is more or less an undisputable issue. Next point that is important for you to keep in mind, is what I like to call the fourth decimal of the WACC. And, and the fourth decimal of the WACC is, you see a lot of people, and this is typical inexperienced people that, when they run the calculations as we’re going to be run. As we are going to run those calculations in Session 4, and they actually try to be very precise. But what they mean by precise, is simply taking a long number of decimals. That is not being precise. Here it is important to remember. And, we’re going to quote Warren Buffett here. That he says, I would rather be approximately right than precisely wrong. Well, many times when you see people estimating the cost of capital, they seem to be aiming to be precisely wrong. They think that because they are taking six decimals. They are actually calculating a very accurate number. That is not what we are going to do. That is not what corporations actually do. So the way that we’re going to approach this is the way that corporations do it. Which is want to have, an idea of the ballpark, on what is our cost of capital so we know. What kind of return, we are going to require from the investments that we make. And so, we’re going to try to be, again, approximately right, other than precisely wrong. Next issue that is important is the, number of terms in the WACC. And, as you’ll see in the expression that we’re going to see a couple of minutes from now, there’s going to be two terms. One term for debt, and one term for equity. And we’re going to explore what’s behind each of these terms and the intuition behind each of those terms. But it’s important that you keep in mind that, although more often than not, you’re going to see a cost of capital written in two terms. One for debt and one for equity. That does not have to be the case. Actually the cost of capital may have, fewer terms than two. There are companies that are fully financed by equity. Say many technology companies. Many companies that are in their very early stages of growth, they are actually fully financed by equity. And those companies will have only one term in the cost of capital, and that term will be equal to the cost of equity. So for companies that are fully financed by equity, the cost of capital and the cost of equity, will be the same thing. Then there are companies like the typical company that we are going to look at that are financed by debt and equity. And that basically implies that there’s going to be one term for debt and one term for equity in the cost of capital, but you can think of many more sophisticated companies. Companies that may actually get financing through, a debt, equity, convertible debt, or preferred stock, or many other possible sources of financing. And each of those sources of financing is going to have a term in the WACC. So a WACC can have, as little as one term, or as many as substantially different sources of, financing, a company uses to invest in their, in their investment operations. And so, our bottom line is, do not get too fixated with the idea that the cost of capital has two terms. It may have less than two terms, or it may have more. Then two terms. And, and final point, and this is more relevant, perhaps, for the next session when we calculate the cost of capital than for this one. Keep in mind that what, what, we are going to try to calculate is something very simple. It is something very essentially. It is very easy to understand what we are trying to aim for. And it’s actually not that com, complicated to calculate. And as I, we, you’ll see in session four it’s not going to be complicated to calculate the cost of capital of the company that we’re going to be dealing with. So the bottom line is. And keep in mind that, what we’re aiming for is something simple, intuitive, essential. Now once we get into the nitty gritty of the numbers, it’s easy to forget that so I wanted to remind you to keep in mind where we’re going, and that is not too difficult to begin with.

The Cost of CapitalAdminCapital StructureCorporate FinancePortfolio ManagementWhat is the Cost of Capital? We are talking about the interaction between, corporations and investors in the market, and they need to interact in a market, because investors are the ones that provide the capital, so that the corporations can invest and produce the goods and services that we like to buy. And,...Investment analysis basics