Do you know your cost of capital?
The other day I was talking to a few local business owners and I asked them if they knew what their cost of capital was. I got a few blank stares.
When we discussed the issue further, people started to warm up to the idea that the cost of capital can be viewed in terms of opportunity costs:
1. One owner said his cost of capital was the interest rate on his bank loans. I suppose he was 100% debt financed and probably not planning to refinance any time soon! Good luck to him!
2. A second owner said he took out all his savings from the bank and put it into his business. Since the bank deposit rate was so low, he figured his opportunity cost was pretty low as well. He has a point, though he must realize that he has moved into a higher risk category by withdrawing his money from the bank and investing it in a start-up business.
3. Another business owner said he started his company by borrowing from his relatives. Since they haven’t asked for it back he assumes its cost is zero. But he does pay a price, I suppose: at family gatherings he gets dirty looks from his relatives and his wife gives him constant grief. He suspects that the relatives complain about him to his wife.
Since all three owners want to expand their businesses, they asked me if I could recommend new sources of finance. I thought of sending them to our P4 candidates (after the exam!).