17 Understand the cost of capital Can I make money from this?
My father was a retailer and a trader. He had strong merchan- dising skills and an eye for goods he could move quickly. If a trade made sense to him, he would do it on borrowed funds.
These were handy skills amid the shortages of post-war Australia in the 1950s. If he spotted a scarce roll of carpet in a warehouse, he would calculate his markup, compare it with his overdraft rate, buy the carpet and then sell it on as quickly as he could. The principle was simple: ‘If you can’t do it with someone else’s money, it’s probably not worth doing.’
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vary, depending on your personal preferences for a certain lifestyle or your goal of reaching a fi nancial target over time.
However, you will still need to look at the most effi cient way of achieving your aim, and you will want to be confi dent that the result will be worth the trouble.
Start with the basic investment decision of choosing your
‘risk appetite’. This is to do with how much stress you want.
You have $100 000 to invest. You don’t want to lose it and you’d like to make some return on it. If you can put it in the bank and earn 5 per cent over 12 months, that is your most hassle-free and best sleep-at-night option. For you, that is the nearest thing to the ‘risk-free rate’ referred to in chapter 16.
It is also effectively the cost of that capital. If you invest it in something else, you are giving up that 5 per cent. There is no point in doing something else unless it can jump over that hurdle. So even if you are cashed up, there is a cost to using the cash you have.
The cost of someone else’s money
If you don’t have the cash and you have to borrow it, the cost of your capital will rise because there is now a risk that you won’t pay it back. Whoever is lending you the money knows they can always get the risk-free rate. So if they are going to lend it to you, they will have to add a margin to cover the additional risk they are taking on you. That’s called the ‘risk component’. Suppose your risk component is 3.75 per cent and the risk-free rate is 5 per cent. The cost of this form of debt can be calculated using this simple formula:
Cost of debt = risk-free rate + risk component
= 5 per cent + 3.75 per cent
= 8.75 per cent
Clearly, whatever you are planning to invest in, whether with your own money or someone else’s, you will need to generate a return that is higher than the relevant rate.
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The cost of equity
The most expensive source of capital is equity. That is because it is the most risky. It is also the most diffi cult to calculate because, unlike interest rates, the rate of return on equity is largely unknown until it is achieved.
Equity costs at least the risk-free rate (because the money can always be put in a risk-free deposit) plus the ‘risk premium’. This premium relates to the risk involved in the project or business it is invested in. This is usually higher than the risk component in the cost of debt because, basically, with equity you have the opportunity to lose everything. With start-ups, people often do.
Think of this as being like buying shares on margin (a practice in which it is also quite easy to lose everything). You will pay interest on what you borrow to buy the shares and you will want a return on the shares that covers not only the lending rate but also the risk you are taking. The equation for the cost of equity is:
Cost of equity = risk-free rate + equity risk premium For example, if you borrowed $100 000 for 12 months and over that period the shares you bought increased by 16.25 per cent, the implied equity risk premium (using our examples so far) would be 11.25 per cent, as shown in this equation:
Cost of equity = risk-free rate + equity risk premium 16.25 per cent = 5 per cent + equity risk premium Equity risk premium = 11.25 per cent
Because the cost of equity is forecast, it is invariably rubbery.
Still, it must be considered a cost of capital because if that capital was earning 16.25 per cent, it wouldn’t make sense to invest it in something else unless that investment would earn more than 16.25 per cent.
There are many indicators you can draw on when working out equity risk premiums in your sector. We will touch on
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these in later chapters. The point is that you need to have a view on what your hurdle rate is when assessing your own business success, or when assessing any new initiatives, be they organic growth projects, taking over a competitor, launching an entirely new business or selling your own.