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February 1, 2019Cost of Capital – How It’s Calculated and Its Effect on Business Risk
As a business owner, you sometimes use gut instinct and common sense guide you. But can you realistically make an unbiased decision about a purchase in your business based on instinct alone? Of course not. You must know whether the cost of your business capital is worth the risk it imposes on your business. In other words, you must know the actual costs of your business purchases to know how they affect the long-term value of your business. So, let’s talk about how to do the math of Cost of Capital calculations.
Business Owners’ Shiny New “Toys”
In my last article, I introduced you to “Jeff.” If you remember, Jeff was a successful business owner who had an extremely profitable business, but his business was basically worthless. Sure, he was making a lot of money, but no one would pay him for his business. Even though it was profitable, Jeff had built a company with enormous risk.
Jeff had all of his eggs in one basket. Although he’d spent time building the business, he’d made some fundamental mistakes. He’d spent most of his money purchasing equipment. Then, he’d depreciated the assets (the pieces of equipment); therefore, the equipment wasn’t as valuable to him as he expected it to be anymore. If he were able to sell his equipment, the recapture tax alone would eat up virtually all of his profits.
Now, Jeff is not alone in his decision making. Many business owners think they “need” to buy expensive equipment at the end of the year to reduce their tax liabilities. However, few weigh the cost of capital of that type of purchase. Few small business owners analyze the pros AND the cons of the business purchases they make. They get caught up in the appeal of a shiny new “toy” or “gadget” that could potentially increase their profits. Or, they fear impending tax payments, so they dump their profits back into their company for a tax write-off.
What is Cost of Capital?
Yet, is dumping money into new equipment for your business the best use of your extra cash? Should you use the money you make from your business to buy more goods or employ quality team members? Should you stockpile the cash into personal investment accounts outside of your business? How do you determine whether to put the cash back into your company or pull it out? Essentially, how do you know where to put your money to get the best return on your investments?
Our journey to build value within your business starts with this topic – your cost of capital.
According to Investing Answers, “cost of capital refers to the opportunity cost of making a specific investment. It is the rate of return that could have been earned by putting the same money into a different investment with equal risk. Thus, the cost of capital is the rate of return required to persuade the investor to make a given investment.” That’s the textbook definition for cost of capital, but what does that mean?
In my financially simple terms, it comes down to one question:
How much is it costing me to make or not make this expenditure? Or, what could I earn by investing my money elsewhere?
The Actual Costs
Let’s say you have $1 million in a bank account that’s earning .25% interest. If you sat on that money, at the end of the year, you would have earned $2,500. However, if you took that $1 million and put it into an FDIC insured Certificate of Deposit (CD) earning 2% interest, you would have earned $20,000. Therefore, the cost of capital to put your money in a CD is $17,500. That’s the money you could have earned. Here’s the equation:
$20,000 – $2,500 = $17,500
Rate of Return from the Higher Yielding Investment – Rate of Return from a Lower Yielding Investment = Cost of Capital
Take it up a notch. Instead of leaving your money in the bank, what if you invested the $1 million into equity stocks, via an ETF or mutual fund, earning a hypothetical return of 10% per year? At the end of the year, you could have earned $100,000. So the cost of leaving your money in the bank would be $137,500. Put another way, you could earn $97,500 more by investing in our hypothetical equity.
$100,000 – $2,500 = $97,500
Rate of Return from the Higher Yielding Investment – Rate of Return from a Lower Yielding Investment = Cost of Capital
Go all out. Take your $1 million and put a 10% down payment on a $10 million business that’s profiting 25% each year. At the end of the year, you could have earned $2,500,000. Therefore, your cost of capital for that investment would be $2,497,500.
$2,500,000 – $2,500 = $2,497,500
Rate of Return from the Higher Yielding Investment – Rate of Return from a Lower Yielding Investment = Cost of Capital
Thus, your cost of capital is what it would cost you if you left your money in a lower yielding investment. It is essentially the amount you could have made had you invested your money elsewhere.
How Cost of Capital Plays Out in Business
So, how does the cost of capital play out in your small business?
Let’s go back to Jeff. I’m going to over-simplify a very complex problem, but let’s assume that Jeff realized a profit of $100,000 in a given year. Rather than pulling the $100,000 out as income (which would increase his tax bill), Jeff wanted to reinvest the money back into his company. He wanted to create an expense within the organization or buy an asset that he could depreciate.
Now, let’s say that Jeff has been eyeing another piece of equipment. By his best estimates, Jeff calculates that this new piece of equipment would generate him roughly a 20% net profit return from his invested capital in the 1st year. In other words, the piece of equipment would generate an additional $20,000 profit for Jeff’s business per year. Notice that’s profit, not revenue.
Jeff realizes he has the ability to invest that $100,000 in another asset. Keeping this illustration super simple, we’ll say that he could put the money into a treasury bond that would yield Jeff 5%, or $5,000 a year. Thus, if we do a simple comparison, we’d say that Jeff would be better served putting his money into the equipment that would yield him a 20% return versus deploying the money into a bond that would only yield him a 5% return. His cost of capital would be $15,000.
How Cost of Capital Relates to Risk
Yet, there’s a caveat. We have to look at risk in our cost of capital equation, and this is where many business owners fail and harm their business’s value.
We already know from talking with Jeff that if he bought another piece of equipment, he’s just pouring gas on a fire. He already has a graveyard of equipment that he can’t sell for what he believes it is worth. And if he were able to sell the equipment, he’ll get hit with recapture tax. Thus, there’s an extremely high risk he can’t resell that piece of equipment.
So, when we start looking at the risk scenarios Jeff faces, we start asking some basic questions.
- Could Jeff invest in another area of his business that would yield a better return than this piece of equipment would (marketing, systems, leadership, etc)?
- Will adding another piece of equipment to his business increase Jeff’s operating costs (employee, insurance, transportation, maintenance, etc)?
- Would Jeff’s equipment purchase add risk to his company or de-risk it? (* This is a major key that many business owners will often glaze over — don’t miss this key point)
- Can this purchase reduce his company-specific risks?
Essentially, we need to know if Jeff’s potential earnings from the area he deploys the capital are worth the known risks. Does the risk of deploying the capital outweigh the benefits it provides? Could he invest the money into a security account or different area of his business that would carry less risk and still make the same kind of return? Should he even deploy the capital at all at this point in the economic cycle or accept distributions from the company to sure up his personal planning?
The Risk
Obviously, risk affects cost of capital. Oftentimes, the higher the risk is, the lower the cost of capital is. The riskier the investment is, the higher your potential for earnings is.
In my equations above, if you invested $1 million into the purchase of a business, you could potentially earn $250,000 within a year, but you could lose your $1 million, too. The business could lose money. It could go bankrupt, or it could close. In that case, your high potential earnings come with high risk-factors. But if you invested your $1 million in the “safe” CD, you could be guaranteed a 2% return on your investment no matter what the economy does. While your earnings are much lower than the 25% return you could potentially earn by purchasing a business, your risk of losing money is virtually non-existent.
In Jeff’s case, if he invests in the new piece of equipment with his $100,000, he could earn 20%. However, the risks he undertakes will be high. His operating costs will increase, and he will never be able to sell the piece of equipment for gain. But, he could earn $20,000 with that investment whereas the low-risk security bond could only return him 5%. In this case, low risk equals low return.
IN-DEPTH READING: Pepperdine Private Capital Markets Reports
What This Means to Me
Customization of the calculation to your specific business is key. You may hear your advisors say, “it depends”. This is not a cop-out, rather the statement is true. So many factors come into the exact calculation to determine the best use of funds for your specific situation.
As a general rule, here are some overly simplified ground rules you can typically apply in your cost of capital calculations:
- High cost of capital = high risk
- Greater risk = lower value
- Less risk = higher value
- Goal – reduce risk
At this phase of your business and growing the value of your company, de-risking is often a primary goal.
To learn more about growing the value in your company, visit our Building a Sellable Business series. It will teach you these and many other topics that make your company more attractive to the business-buyers when you are ready to retire.