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.
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.
Traditionally it has been thought that cost of equity should be higher than debt bcos the equity provider gets to participate in the upside (when the profit grows, stock price rises) but the debt owner will always only receive the fixed interest. So cost of equity will at least be 6% or more. In the 1950s or maybe 60s, academics tackled this question in a big way and came out with a huge model called the CAPM model. This is huge and Nobel prizes are given and economists became gods. For those interested, you can go wiki it or something.
Basically the idea is that cost of equity can be expressed in an equation like
Cost of equity = risk free rate + equity risk premium
The equity risk premium part can be further broken down into super complicated stuff like beta and expected market return which are too mind-boggling for our purposes here so it suffice to say that this equity risk premium should be a no. to compensate equity investors for the risk they take and make the total cost of equity higher than cost of debt.
Historically, cost of equity is about 6-8% for most large cap companies.
So the equity risk premium is about 3-5% (bcos risk free rate, which is usually long term government bond yield is about 3%)
Combining the two, you get something called the WACC (for weighted average cost of capital), and this is the cost of capital for a company. This no. usually ranges from 5-7% judging by the no.s given above.
It is said that companies should earn more than its cost of capital to justify its existence. So meaning the co. should have a return on capital of at least 5-7%. Capital meaning debt + equity, or roughly speaking total asset of the company (not exactly the same thing but close). If the co. has no debt, it means that the return on equity (the famous ROE), should jolly well be above 6-8%, ie above the cost of equity.
If a company cannot generate this return, then investors should really pull out all the funds and invest in others that can. However, in real life, that is not always the case, as we shall explore in the next post.