What Is Real Cost of Capital?

The cost of capital is the opportunity cost of investing capital. This kind of cost is not the cost actually paid, but a lost return, it is the return of other investment opportunities abandoned by the investment of capital for this project, so it is called opportunity cost. For example, the purpose of an investor's investment in a company is to obtain returns. Whether he is willing to invest in a particular company depends on whether the company can provide more compensation. To do this, he needs to compare the company's expected return to that of other venture capital opportunities. If the company's expected return is higher than all other investment opportunities, he will invest in the company. The benefit of other investment opportunities he gave up was the cost of investing in the company. Therefore, the cost of capital is also called the rejection rate of the investment project and the minimum acceptable rate of return. ^[1]

Cost of capital

The cost of capital is the opportunity cost of investing capital. This kind of cost is not the cost actually paid, but a lost return, it is the return of other investment opportunities abandoned by the investment of capital for this project, so it is called opportunity cost. For example, the purpose of an investor's investment in a company is to obtain returns. Whether he is willing to invest in a particular company depends on whether the company can provide more compensation. To do this, he needs to compare the company's expected return to that of other venture capital opportunities. If the company's expected return is higher than all other investment opportunities, he will invest in the company. The benefit of other investment opportunities he gave up was the cost of investing in the company. Therefore, the cost of capital is also called the rejection rate of the investment project and the minimum acceptable rate of return. ^[1]

Different understandings between China and the West

The following lists China's misunderstanding of the cost of capital

In China's financial management, the cost of capital is probably the most confused concept. People's understanding of it is often based on superficial observations. For example, many people think that the borrowing rate is a typical representative of the cost of capital.

Measurement of the cost of capital

The cost of capital can take many forms. Comparing various

Misunderstanding of the cost of capital

The larger the total value the company hopes to create, the better. If you consider the cost of capital, this traditional view of profit calculation will change.

Misunderstanding that the higher the profit, the faster the company will add value

Under the market economy system, enterprises must pay a certain price to raise funds from various funding channels, and cannot use it for free. We usually call the cost of capital for the various costs paid by an enterprise to obtain and use capital. The value created by an enterprise should be the profit after tax minus the operating return on capital cost. The absolute number is expressed by the formula: value created = profit after tax without interest deduction-cost of capital. The amount of capital investment is the actual amount of capital occupied by the business operation. The specific calculation includes readjustment and consolidation of assets and liabilities on the balance sheet: capital investment = equity capital investment + debt capital investment. The most common method for calculating the cost of capital ratio is to use a capital asset pricing model: weighted capital cost ratio = equity capital ratio × equity capital cost ratio + debt capital ratio × debt capital cost ratio.

The created value formula reveals the source of enterprise value. If the created value is positive, the enterprise will add value. The greater the value created, the more value will be added. If the value created is negative, the enterprise will be impaired. Profits do not have this clarity. Profits are positive, and the company may not add value. Intuitively, the value created by a company seems to consist of the profits of the company, but this is not the case: the calculation of profits does not take into account the opportunity cost of equity (returns lost by giving up other investment opportunities). Only the profit excluding the cost of equity capital is the part of the value created by the company, because the opportunity cost of equity is deducted from the profit to truly see whether the value of the company has increased, that is, only the value created is the source of the value of the company, and the profit is only an appearance That's it. The cost of capital ratio is also often seen as the lowest rate of return. Because an investment project must strive for a minimum rate of return in order to compensate the cost of capital used by the enterprise to run the project, otherwise the investment is unreasonable or loses money. Of course, the cost of capital is also an opportunity cost. For example, a capital has two investment projects A and B. The investment profit rate of project A is 10% and project B is 14%. If you choose B, you must give up the profit of 10%. Opportunity project A. Here 10% is the opportunity cost of the capital of project B.

Think of equity financing as a "free lunch"

There is a common misunderstanding among Chinese enterprises, and equity financing is regarded as a "free lunch". Due to the clear level of debt capital interest rates and repayment of principal and interest, enterprises generally feel the existence of the cost of debt capital, but do not feel the pressure of the cost of equity capital. Therefore, the company has formed a so-called "free capital illusion" since the initial public offering of funds, that is, the biggest benefit of equity financing is that it can allow enterprises to obtain permanent capital, without the pressure of repayment of capital and the need to pay dividends. In fact, "there is no free lunch", and corporate capital obtained in any way has to pay a price. For example, if a company occupying 1 million yuan of assets can only achieve a 5% return on assets with an average social return of 10%, then the company should have a loss of 50,000 yuan on its books instead of a profit of 5 Ten thousand yuan.

Not paying attention to the cost of inventory backlog

Many domestic companies do not pay attention to inventory management, or the inventory management is unreasonable. In order to prevent product out of stock and a large backlog of inventory, or because of confusion in management, the cost of inventory has risen, although the enterprise can operate normally, it has an additional expense. Because inventory is one of the largest assets of most manufacturers, distributors, and retailers, its volume may account for more than 30% of the total assets of manufacturers, and more than 50% of the total assets of distributors and retailers. Keeping a lot of inventory means taking up a lot of money, and the inventory itself incurs costs.

In this case, companies can use the ABC control method to reduce inventory levels and accelerate capital turnover. That is, according to the importance of inventory, it is divided into three types of ABC. Category A inventory types account for 10% to 15% of total inventory, funds account for about 80% of total inventory, and key management is implemented; Type B inventory is general inventory, varieties account for 20% to 30% of total inventory, and funds account for total inventory 15%, appropriate control and daily management; C-type inventory types account for 60% to 65% of total inventory, and funds account for about 5% of total inventory for general management. Normally, companies do not need to keep a large amount of inventory. In this regard, they can learn the "instant system" implemented by Toyota in Japan. This is called "demand Kanban" in Japan, just like people who fill shelves in supermarkets see Kanban "** "Short cargo", immediately fill in the scene. This "real-time system" pull mode can eliminate unnecessary inventory on the one hand, and on the other hand, it can greatly reduce the moving time and inspection time between departments, thereby shortening the manufacturing cycle and reducing the cost of the enterprise. And put forward high requirements for quality. Because if a problem arises and cannot be resolved in a timely manner, then the entire production pull will be invalidated, and the enterprise's production will be completely paralyzed.

Insufficient fund activation and effective operation

Inventory cash can largely reflect the financial management level of enterprises. Recent data show that China's current savings rate is as high as 46%, household savings deposits are 14 trillion yuan, and corporate deposits are 10 trillion yuan, and the growth momentum of corporate deposits even exceeds that of residents. This is reflected from the side. Some companies do nt know how to dispose of the surplus cash. Most of them have turned to banks and ignored reinvestment. If there is no cost to holding these funds, then the company will not have any restrictions on this surplus of funds, which will cause investment expansion and waste of social resources, and from the perspective of information usefulness, the company's book cost will be separated Due to the true cost of society, the profit of an enterprise has little economic value.

In order to make reasonable and effective use of corporate funds, it is necessary to start with corporate performance assessment, raise awareness of capital costs from the system, and ensure the effective use of funds. Specifically, it is necessary to consider the cost of capital in the performance indicators of enterprises to avoid the illusion of "free use" of corporate funds, prompting companies to pay attention to the effective use of funds and truly achieve the goal of "preserving and increasing value".

In real life, people often pay attention to the cost concept of financial accounting, that is, expenses are the various expenses incurred by the enterprise in the production and operation process, but they do not realize that the occupation of funds also has to pay a price, and to a certain extent it pays The cost far exceeds the cost of capital. Therefore, only by correctly establishing the cost concept of modern corporate financial management, especially based on the concept of capital cost, and paying full attention to the cost of capital occupation, can we make correct long-term and short-term investment decisions and avoid long-term occupation of corporate funds Or freeze, accelerate the flow of corporate funds, use corporate funds reasonably and effectively, and improve the efficiency of corporate capital use, thereby further revitalizing assets and optimizing corporate asset structure.