What is the Cost of Capital

Summary

In this video, Ken McIlroy discusses the concept of 'cost of capital,' which encompasses all forms of money, including debt, equity, and hard money. He emphasizes the importance of considering the cost of capital as an expense that impacts cash flow. McIlroy advises that in a market with abundant capital, one should focus on securing the lowest cost of capital possible to increase cash flow. He warns that a high cost of capital can jeopardize a deal's profitability, as seen in the last recession, and stresses the need for careful negotiation of terms to ensure financial success.

Takeaways

• 💼 The concept of 'cost of capital' is central to understanding money, lending, debt, and equity.
• 💹 Different types of financing, such as debt, equity, hard money, mezzanine financing, and mortgages, all contribute to the cost of capital.
• 📈 The cost of capital is calculated by blending various sources of financing, considering both high-interest loans and lower-interest bank loans.
• 💰 The cost of capital is an expense that impacts income, similar to insurance payments, and is crucial for evaluating financial decisions.
• 🔍 When seeking financing, it's important to focus on the terms and the cost of money, as it can vary significantly.
• 📉 Lowering the cost of capital can increase cash flow, which is beneficial for any business or investment.
• 🏦 Currently, there is an abundance of money available from various sources like Wall Street, private institutions, pension funds, and banks.
• 🏗️ Lenders and investors assess the risk of a deal, which influences the cost of capital; higher risk often means a higher cost.
• ⚖️ It's essential to be cautious about the source of capital and its terms, as a high cost of capital can negatively impact a deal's viability.
• 📉 A high cost of capital can erode cash flow, potentially leading to property being reclaimed by lenders or investors, as seen in past recessions.

Q & A

What is the main concept discussed in the transcript?

The main concept discussed in the transcript is the 'cost of capital,' which refers to the total cost of different sources of money used in a business, including debt, equity, and other forms of financing.

Why is the cost of capital important for a business?

The cost of capital is important because it represents an expense that goes against a business's income. It affects the cash flow and profitability of the business, and a lower cost of capital can increase cash flow and potentially improve the overall financial health of the company.

How does a high-interest loan impact the cost of capital?

A high-interest loan increases the cost of capital because it represents a higher expense for the business. When blended with other sources of capital, it can raise the overall cost of capital, which can negatively impact the business's cash flow and profitability.

What does the speaker mean by 'blended amount of money'?

The 'blended amount of money' refers to the combined cost of different sources of financing when they are used together in a business. The speaker suggests that the cost of capital is calculated by averaging the interest rates of these different sources.

How does the availability of money affect the cost of capital?

When money is plentiful, as suggested by the speaker, it can lead to more competitive interest rates and potentially lower the cost of capital. However, it's important for businesses to still focus on negotiating the best terms to minimize the cost of capital.

What factors does the speaker suggest can influence the cost of capital?

The speaker suggests that the cost of capital can be influenced by the terms of the financing, the risk associated with the investment, and the overall market conditions. For example, a risky investment like a ground-up construction deal may have a higher cost of capital compared to a less risky, established business.

Why is it crucial to negotiate the terms of financing?

Negotiating the terms of financing is crucial because it directly affects the cost of capital. By securing the lowest possible cost of capital, a business can improve its cash flow and potentially increase its chances of success.

What does the speaker imply about the current financial market?

The speaker implies that the current financial market is favorable for borrowers, with money being plentiful and various institutions, including banks, pension funds, and insurance companies, being willing to lend.

How does the risk of a deal affect the cost of capital?

The risk of a deal directly affects the cost of capital. Higher risk deals, such as those involving new construction, may require a higher cost of capital to attract investors or lenders, who demand higher returns to compensate for the increased risk.

What is the consequence of not being able to cover the cost of capital, as mentioned in the transcript?

If a business cannot cover the cost of capital, it may face financial distress, leading to the property being taken back by the lender or investor. This was observed during the last recession, where properties were foreclosed or repossessed due to inability to meet the cost of capital.

What advice does the speaker give regarding the source of capital?

The speaker advises being cautious about the source of capital, considering the cost and terms of the financing. It's important to ensure that the deal is sound and that the cost of capital does not jeopardize the business's financial stability.