BLOG 1# Cost of capital - An Introduction

Hi Friends!!!!!

Good Morning.

Am really excited to write my first blog. I thought of various topics but finally landed on this Cost of Capital since I sense the understanding of this topic is fairly lower in student community.

So, What is Cost of Capital? Google it, you will get crores of  pages with a lot of meaningful content. But at the end you still have the same confused face. Let me put it very simple.

Remember, there is no FREE LUNCH. Everything has a cost. (Moms love and certain others are exceptions thou).

Business needs capital. Capital comes from different sources, Own money (Equity) Borrowed Money (Debt) etc. In more detail if we talk, it can be
a) Equity Share Capital
b) Preference Share Capital
c) Retained Earnings (Reserves)
d) Debenture Capital
e) Long term loans from banks and other institutions

All these are called sources of finance.

Each source has different characteristics as to
1) its cost (Cost of Capital)
2) Risk (Risk of fixed finance cost and burden of repayment)
3) Control (dilution of control if its equity)

So, friends, imagine you have started a business. Also, imagine you have borrowed Rs. 1 Crore from your dad. (and no need to mention, majority of  parents are against this and they prefer you get a decent job except you hail from a business community). You wanted to prove yourself to the world (the common mistake youth does instead of proving self first) by earning big money and becoming successful in life. You worked really hard round the clock through out the year and finally got profits. At the end of  the year you prepared P&L A/c and to your happiness it resulted in a profit of Rs. 5,00,000. You are extremely happy, went to your dad with a head held high and said, "Dad! See my earnings. I got Rs. 5,00,000. This is the result of my hard work of the whole year. Tell me now. How did i do?" Dad Smiles at you and says, thats good, Congos, Keep it up. But you are not happy, you try to dig the inner layers and asked, dad whats the logic behind your smile. Then Dad Said, Beta,
a) You have done business, worked hard throughout the year, converted your blood into sweat and earned Rs. 5,00,000
b) If you do not do anything and just let the money be there in the bank's Fixed Deposit a/c as it was before you started business, it would have earned Rs. 7,50,000 (assuming an interest rate of 7.5% p.a)

But anyway still you have done a good job since this is the beginning. Still, there is a  big moral in the story.

Whats the conclusion?
IF YOU EARN MONEY, ITS NOT ENOUGH. YOU NEED TO EARN ENOUGH MONEY.

This is the primary reason, why in the basics of finance, your teacher might have told you the thumb rule, which is, accept the project / business only when its Return on Investment (ROI) is higher than the Cost of Capital (CoC). [ROI > CoC]. This means your new business or project should not only earn profits, it should earn profits higher than the cost of capital.

So, Friends, finally the logic is, money has opportunity cost. You should earn above it. In the above example, if you have earned anything above Rs. 7,50,000 the story would be different.

Now, Understand the following:
1) Since the above money is pooled from your OWN sources (Equity), you need not pay interest. There is no actual interest cost but there is OPPORTUNITY COST.
2) If you borrow money (Debt), you will have to pay interest cost to the lender of the finance which is ACTUAL interest cost.