Some Thoughts on the Cost of Capital

For most of our small and medium sized business clients – capital adequacy is foremost a cash flow consideration – as it should be.  When it comes to sourcing marginal capital and evaluating the associated costs, however, many clients tell us they struggle with their decision making process.  Sure they can spot a darn good deal when they see one, but in today’s environment darn good deals on capital are fewer and further between.  So what are some tips a business owner can use?  Below are a few we think make good sense, and in our experience also commonly challenge our clients:

1.  Absolute cost matters, but relative cost matters more

When faced with a higher than expected cost proposition business owners instinctively recoil.  And while there is no question that less (as it relates to costs) is always better, it is important to consider the cost of capital relative to the return potential of the project.   Consider an example where a business owner has identified an excellent investment project (e.g. potential for 30% ROI), but is faced with an unusually high cost financing proposition – at least compared to his historical borrowing costs (e.g. 15%).  Faced with this set of facts, many business owners will simply refuse to accept the “high” borrowing costs and will not proceed with the investment.  In this example (and taken in isolation), however, passing on the opportunity would not be the rational value maximizing decision – when an opportunity to 15% net is presented.  Some might now say 15% is not enough!  To which we say OK – but that’s not the point we are trying to make.  Our point is simply that it is not optimal to forgo an attractive investment project that meets your risk adjusted return criteria (whatever it may be and after considering your cost to finance it) solely because the cost to finance it is deemed too “high”.

2.  Make sure the math makes sense

We frequently run across companies in narrow margin businesses.  When we discuss whether or not some level of borrowing could make sense, we often hear something like “I only earn a 5% margin, so borrowing for more than 5% doesn’t make sense – as it will simply consume the margin.”  This is an apples and oranges comparison.  If a business earns a 5% margin and turns over its sales in 45 days (for example), then the 5% margin is earned 8 times during the year (360 days divided by 45 days) which is 40%.  In this example it is the 40% annual figure that should be properly compared to any annual borrowing costs.  Although it may seem reasonably obvious when presented in this manner, it is discussion we encounter frequently in our day to day conversations.

3.  Remember that invested capital includes both debt and equity

The optimal level of borrowing (if any) is different for each business.  And every business maintains a level of invested capital (equity and/or debt) all of the time.  So the question becomes can some level of borrowing reduce the cost of capital (i.e. contribute to greater profitability) – since debt is generally a less expensive form of capital than equity?  The answer is “yes” – in the right circumstances.  Since there is no A+B=C formula for determining the “right” circumstances, some general guidelines are offered below:

Some business characteristics that support greater borrowing include – sales not highly sensitive to the economy, reasonably stable profit margins, consistent profitability, ability to adjust costs to meet higher or lower demand levels, low to modest ongoing capital investment required, etc.

Those business characteristics that support less borrowing are generally the inverse of the above.  If your business can support borrowing, doing so will reduce your cost of capital.  In fact, borrowing at the proper levels is likely to be a necessity for such businesses as competitors will almost certainly be doing so.