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For What It’s Worth: The Cost of Capital – August 2016

The cost of capital is arguably the most complex aspect of business appraisal.  Most people are not familiar with it and find it hard to understand.  This letter tries to explain it simply.

When we buy things, the cost is what we pay, and the benefit is what we get.  If the benefit exceeds the cost, we gain (profit) from the transaction.  Some costs and benefits are easy to measure (quantify in dollars).  If we can buy a Coke for $1 and sell it for $2, the cost, benefit, and gain are simple to quantify and the decision is easy.  Some costs and benefits are difficult or impossible to measure.  What is the full cost of hospitalization for a risky medical procedure that might cure you, impair you, or kill you?  It is not just the dollar cost, but also the possible loss of (quality of) life!

When we (individuals or businesses) invest, we use cost / benefit logic.  It is more complicated, however, because costs and benefits accrue over many years.  The cost of an investment is not only what we pay up front.  It is also what we give up over the life of the investment – return we could have earned on our money had we not made the investment (called the “opportunity cost”).

If we own a company that earns a high return, an investment (say, in equipment, research and development, or even another company) makes economic sense only if its expected return exceeds what the business already returns.  If it earns less, it will reduce (dilute) the business’s total return on investment.

Moreover, if our company lacks capital to fund the investment, it must raise more.  It will have to pay lenders and investors a sufficiently high return on their capital to entice them to invest in our company.

Our company’s return and the return required by new investors in it are its cost of capital – the return existing investors give up and new investors require.  The economic return on investment has to exceed the economic cost of capital.

That is the concept of the cost of capital.  In reality, it is difficult to estimate.  This is because it reflects expectations about the future.  We cannot precisely quantify it.  We cannot know what a given investment will return, because of uncertainties about the economy, the industry, the company, and many other factors.  We do know that risk and return go hand in hand: a low-risk investment requires a low rate of return, and a high-risk investment requires a high rate of return to compensate investors for the risk they assume.  If there were a high-return, low-risk investment, investors would compete for it by raising the price they would pay, which would lower its rate of return.

Do not be intimidated by appraisal reports that estimate risk and return using complicated methods.  All of them rest on assumptions and math.  Verify those assumptions, and let us do the math!

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About Western Reserve Valuation Services LLC
Western Reserve Valuation Services LLC, based in Columbus, Ohio, is a leading provider of valuation services and financial opinions relating to corporate finance transactions, corporate tax planning and compliance, succession planning and wealth preservation, employee stock ownership plans (“ESOPs”), financial reporting and portfolio / fund valuations. For more information, visit www.wesresvaluation.com or call (614) 448-3700.

Western Reserve Valuation Services is an affiliate of Western Reserve Partners LLC, a FINRA-member investment banking firm offering financial advisory services relating to mergers and acquisitions, capital raising and financial restructuring. For more information on Western Reserve Partners, please www.wesrespartners.com or call (216) 589-0900.

Representative clients

  • Huntington Scroll

  • American Industrial Partners Scrollbox

  • Cortec Scrollbox

  • Evapco Scrollbox

  • CFS Scrollbox

  • Stanley Steemer Scrollbox

  • Veeam Scrollbox

  • Catterton Scrollbox

  • Hamilton Beach Scrollbox

  • Optimus Scrollbox