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Cost of capital: a timeless statement

Lesson in Course: Medes Newsletter (advanced, 4min )

What is the cost of capital? I have heard this before but what do I need to know?

I currently live in Manhattan and I walk through neighborhoods with very extravagant homes every evening—a nice brownstone in the Village will run you for about $10 million today. A recent Bloomberg article caught my eye with the title “Mortgages Are Now in Vogue for Manhattan’s Luxury Condo Buyers.” The title is just dripping with New York; however, what is notable is the opening sentence:

“For the world’s wealthiest, paying cash for a lavish Manhattan apartment was the ultimate status symbol. These days, even those buyers would rather get a mortgage.”

In the real estate business, cash is 👑. An all-cash offer is fantastic because it allows the purchaser to cut the line of competition and it allows the seller to avoid taking the risk that the property does not appraise to the loan value. Intuitively, an all-cash offer is justifiable because we are all taught that debt is bad. Why have debt when there’s enough cash to cover the purchase?

 

Also, why do corporations take on debt? For example, as of September 28, 2019 Apple had $206 billion in cash, cash equivalents and marketable securities, while also having $102 billion in term debt.

Counter to what many people’s intuition says, the borrowing of money (responsibly) is actually a good thing due to opportunity cost and the cost of capital. Understanding both helps us become better investors.

 

Opportunity cost

The opportunity cost is the cost of a certain decision or opportunity. For example, the common decision of eating lunch every day presents an opportunity cost. The time invested in preparing lunch or money invested in buying lunch is the explicit cost of having lunch. Alternatively going hungry is the implicit cost of not having lunch. No matter which side of the decision there’s going to be a cost. In finance and investing, opportunity cost exists at every decision as well.

For example, while looking at buying a house for the first time, the opportunity cost breaks down accordingly:

Buying— The cost of a loan if financed, and the lost earning power of the cash (e.g. what the down payment can generate in the stock markets).

Not buying — (The cost of continuing to pay) rent and not participating in any upside of the appreciation in value of the property.

As long as the cost of buying is less than the cost of not buying, the decision is a good one (financially).

 

Cost of capital

The cost of capital is how much an individual or a business pays to acquire money. Traditionally with a loan or debt, the cost of capital is the amount owed in interest — more commonly referred to as the cost of debt. Certain companies can also raise money by selling shares or ownership. By giving up ownership, the cost is called the cost of equity.

For most startups, the operating history is limited and thus considered too risky for most debt financers since there’s very little guarantee that the startup will be able to pay the money back. That’s why typically venture capital provides equity financing for startups. In almost all cases, the cost of equity is often magnitudes higher than debt financing. For example when Uber IPOed, venture capital firm Benchmark Capital, the same firm that sued former CEO Travis Kalanick, owned $6.8B worth of Uber shares for $12M invested. No bank can ever charge $6.8B worth of interest on $12M loaned.

The combined cost of debt and equity creates the cost of capital. Most financiers raise the amount of money needed for an investment or purchase with the lowest total cost of capital possible.

 

Monopoly winning move: mortgage properties to buy hotels

Regardless of how wealthy the individual is, by considering opportunity cost and the cost of capital, taking out a mortgage is the wisest thing to do. At recent market rates, investing in an index that tracks the S&P500 would result in a ~10% annual return before factoring in taxes and inflation. The cost of debt, on the other hand, is just about 3.5% on a typical 30-year mortgage from Wells Fargo.

🤔

Let’s say we have $1M on hand to buy a house. Getting $650k financed through a mortgage means that we can then put $650k of our own money into the stock market. Assuming returns hold steady, 10% annually is about $65K in returns while the mortgage costs roughly $23K*. 🔥

*Note, I have greatly simplified how interest is calculated just to make a point*

It seems like to me what’s in vogue is just good financial practice.

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