Intuition behind cost of capital
I know cost of capital is based on the returns expected by those who provide capital for the business, which is provided in the form of debt and equity. But what about the company's balance sheet as a source of capital?
Isn't cash from the balance sheet used to finance projects? Why is the 1% return the company gets on treasury bonds not part of its cost of capital since it can finance projects with its own balance sheet too?
Never took accounting in college so I might have some conceptual misunderstandings. I'd really appreciate any explanation the forum can provide!
In theory if you were to finance a project with 100% cash then that would be your cost of capital. Depends on the mix of financing.
Cost of Capital (in theory) is better suited for looking at projects rather than whole companies for this reason.
Could you elaborate? Are you saying the cost of capital would be 0 if you finance a project exclusively with cash?
That doesn’t make any sense and misses the point. Cost of capital isn’t about how you funds your investment but at the type of investment. If the only investment around was cash, then your cost of capital is the cost of cash.
The cost of capital is set by investors who play in your asset class. If you’re a high risk growth company, your cost of capital is high because the reward investors demand for risky projects should be greater than the risk free rate, equity returns and other high risk projects because those investments are available to investors as well so for them to give you capital you need to at least provide those returns
Does that make sense
The cost of capital, conceptualized in June of 1685 in East Guinea, is a shoot off of the 1537 Croteshian theory of economic trapezoidal Syllatomorphism. Simply put, money costs money - a truism of which we can all relate.
What about cash on your balance sheet? When you finance a project, that doesn’t cost anything right?
Lol bruh did you just word vomit the biggest words you can think of? This statement made no sense whatsoever
Hahaha
Would it be helpful if I pointed you to some literature on the topic?
Let me know when you have 6 or 7 free hours of bandwidth and we can go through the nuances.
.
Peanut butter
Well technically that 1% treasury rate the company could get by financing with cash is already accounted for in its cost of capital. Cost of debt and cost of equity both use the treasury rate as a floor for their own expected returns.
I guess another way to think about it is, while yes, a company can use all of its own to cash to finance its projects, the cost of using that cash isn't 0%. That's because of the opportunity cost of not using that cash for something else (buying treasuries, investing in another company's stock, pursuing a different project, etc).
If a company can get a 1% risk-free rate by using its cash to buy treasuries. Then it will always be giving up that 1% to use its cash for anything else.
Thanks for this reply! That makes sense with how I was thinking about it, but why does the WACC formula only account for debt and equity financing?
Because those are the forms of capital raised from investors. If they had preferreds or other forms of capital to finance the business those would factor into the companies WACC as well.
.
Thank you!
Distinctio dolores qui ipsum incidunt sed. Qui laudantium ut fugit illum. Tempora eveniet ea delectus eligendi est est aut. Odit id dolores quibusdam.
Magni facilis et doloribus sit totam esse. Inventore et odit eum corrupti velit voluptates. Doloremque in architecto voluptas ut quo voluptatem dolor eligendi. Iste officiis quis accusamus eligendi voluptas. Sint vero ut quam vel. Quia et ducimus corrupti dolorem voluptatem velit. Incidunt perferendis pariatur velit numquam velit.
Est incidunt dolores quas rem autem et sed. Est saepe quia non velit. Tenetur vitae ducimus asperiores recusandae laborum ab dolorem. Sed minima repudiandae repellendus et. Numquam ut nostrum dignissimos occaecati.
Tempora non quis autem nihil consequatur maxime error qui. Deleniti nihil magnam minus nostrum quo.
See All Comments - 100% Free
WSO depends on everyone being able to pitch in when they know something. Unlock with your email and get bonus: 6 financial modeling lessons free ($199 value)
or Unlock with your social account...