Posted on September 30, 2009 - by Jay

Cost of Capital

Photo by circo de invierno

We are back to talking about something dry after a long, long hiatus. Ok Cost of Capital.

Basically, capital is not free, it comes at a cost.

Why is there such a cost? Well basically the person providing the capital needs to earn a return. If not, he might as well chuck it under his pillow right?

So the question is how much return does he want?

Well, the lowest return he can get without any risk of his original amt being reduced is 3% or so. That is if he buys government bonds. So the cost of capital cannot go below 3%.

Capital actually comes in two forms: debt and equity. Let’s talk about the cost of debt first, bcos it’s easier.

Debt
Say you want to start a company today and need money, so you go to a bank and ask for a SME loan. Depending on the nature of your business, your bargaining ability, the desperation of the loan officer, your interest on the loan should be around 6-10%, which is pretty high. Well that’s bcos it’s SME, may go any time one. So the bank needs some buffer. If a big Fortune 500 firm issues a bond, they can probably get US$100mn with interest rate of 4+% or so.

So the cost of debt is just that: 4% to maybe 6% for most large cap companies. Read more…

Related posts:

1. Cost of Car Ownership Calculator
2. Capital Prudence
3. Recycling and Reallocating Capital