What is the Cost of Capital?
Corporations and investors 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
- How do investors think about other investments?
- How they evaluate investments in terms of returns?
- How they evaluate investments in terms of risk?
- How investors form portfolios?
- What is the role of correlation and diversification in the formation of those portfolios?
Corporate finance is about the interaction between the 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. We cannot really leave investors completely out of the picture. However, it mainly focuses on corporations, their policies, and what they do.
CAPM and Cost of Capital
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. Here we will look at the intuition and understand
- What is the idea of the cost of capital?
- What are the components of the cost of capital?
- Moreover, what is the intuition behind, each of the components of that cost of capital?
- How to calculate the cost of capital, for a particular company, at a particular point in time.
The cost of capital is an essential variable for any corporation. When we, think about the cost of capital, and we actually estimate the cost of capital.
Most people think that cost is implying that money’s coming out of a corporation. The cost of capital rather gives you the idea that the company is paying, for something, but that is not really, what we are going to calculate.
What is WACC (weighted average cost of capital)?
- The cost of capital is not really all that much related to cash flows.
- The cost of capital is really related to risk.
- 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, 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 arguably and undisputable issues. 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.
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 the cost of capital, we are also going to find arguable issues. 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 is no consensus. Sometimes people tend to converge around, this is a better way of doing things than some alternative ways. However, it is not going to be like those undisputable issues. It is not, that just about everybody is 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 will let, I will let 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 essential. It is very easy to understand what we are trying to aim for and it’s actually not that complicated to calculate the cost of capital. And keep in mind that, what we are aiming for is something simple, intuitive, essential.