What Makes An Appetizing Investment?

What rate of return should companies strive to earn on their investments? Higher rates may appear more appetizing of course, but it really depends on the cost of capital.

The cost of capital is the interest rate paid on various forms of financing. When investing the capital, the goal is to generate a higher rate of return than the rate promised to those who provided the financing.

Photos by nutmeg, courtesy of flickr

For companies, the cost of capital is usually determined by finding the weighted average of the rates paid on three types of financing: common stock, preferred stock and bonds.

I teach the concept of the weighted average cost of capital (WACC) to my corporate finance students. Sometimes, formulas initially confuse students, so I explain them in terms of food. That goes over pretty well.

Suppose, you are a restaurateur and your menu offers an appetizer sampler that is 1/3 fried ravioli, 1/3 stuffed mushrooms, and 1/3 calamari.

Let’s further suppose that the dish costs you $6 to make. In order to profit, you must sell the sampler for something greater than $6. The cost, $6, is your hurdle.

Now, suppose a customer asks for the sampler with 2/3 calamari and 1/3 mushrooms. The cost to you may now be $7. As customers change the composition of the sampler, your profits from the sampler may grow or shrink. (This is part of the reason why you may see “no substitutions” on many menus.)

My point is that using the same three inputs in different proportions will produce different costs. In the corporate world, the three inputs have different costs. Perhaps the cost of equity (common or preferred) may be higher than the cost of debt (bonds). Each cost will play a part in deciding what to do with the capital.

So, when selecting how capital is invested, companies need to (at the very least) clear the cost of obtaining the capital.

BTW – The cost of capital may also be referred to as the discount rate or required rate of return.