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.

Outlines

00:00

💼 Understanding the Cost of Capital

Ken McIlroy introduces the concept of 'cost of capital' as a crucial factor in financial decisions. He explains that regardless of the source, all forms of money—be it debt, equity, hard money, or mortgages—contribute to the overall cost of capital. This cost is essential as it influences cash flow and is an expense that must be accounted for in any financial endeavor. Ken uses examples of high-interest loans and bank loans to illustrate how the blended cost of different sources of capital can impact a project's financial viability. He emphasizes the importance of securing the lowest possible cost of capital to maximize cash flow, especially in a market where money is readily available from various sources like Wall Street, private institutions, pension funds, and banks.

Keywords

💡Cost of Capital

The 'cost of capital' refers to the minimum return that investors require for providing capital to a business. It is a critical concept in finance, encompassing all forms of financing, such as debt, equity, and other forms of funds. In the script, Ken McIlroy emphasizes that regardless of the source of funds, the cost of capital is the key factor to consider. It's an expense that impacts the profitability and cash flow of any business venture. For instance, he explains that blending different sources of capital, like a high-interest loan and a bank loan, results in an average cost of capital, which is essential for evaluating the financial health and sustainability of a project.

💡Debt

Debt is a liability that arises when a borrower receives funds from a lender with the obligation to repay it with interest. In the context of the video, debt is one form of capital that businesses use to finance their operations or investments. It's highlighted as a component of the cost of capital, and its interest rate is a significant factor in determining the overall cost of capital. For example, a high-interest loan would increase the cost of capital, which could affect the feasibility of a project.

💡Equity

Equity refers to the ownership interest in a company held by shareholders. It represents the residual value of the company after deducting all its liabilities. In the video, equity is mentioned as another form of capital that contributes to the cost of capital. It's the money invested in a business in exchange for a share of ownership, and it typically carries less risk than debt, which is reflected in a lower cost of capital.

💡Interest Rate

The interest rate is the cost of borrowing money, expressed as a percentage of the principal. It's a key determinant of the cost of debt and thus the overall cost of capital. In the script, Ken McIlroy uses the example of a high-interest loan at 8-10% and a bank loan at 3-5% to illustrate how different interest rates from various sources can affect the blended cost of capital.

💡Cash Flow

Cash flow refers to the net amount of cash and cash-equivalents being transferred into and out of a business. It's a measure of the liquidity and solvency of a business. In the video, cash flow is highlighted as a crucial metric affected by the cost of capital. A lower cost of capital can improve cash flow, making a business more financially stable and potentially more profitable.

💡Negotiation

Negotiation is a process where parties discuss and agree on the terms of a transaction. In the context of the video, negotiation is essential when seeking the lowest possible cost of capital. Ken McIlroy advises that one must negotiate the terms of financing to ensure the cost of capital does not hinder the success of a venture.

💡Risk

Risk in finance refers to the possibility of losing some or all of the funds invested in a project. It's a critical factor that influences the cost of capital. The video script mentions that riskier projects, such as ground-up construction deals, may have a higher cost of capital due to the uncertainty and potential for loss. Conversely, less risky, established investments like fully occupied apartment buildings may have a lower cost of capital.

💡Lender

A lender is an individual or institution that provides funds to a borrower with the expectation of receiving repayment with interest. In the video, lenders are shown as entities that assess the risk of a project and set the cost of capital accordingly. The script emphasizes the importance of understanding the perspective of lenders when seeking capital.

💡Investor

An investor is a person or entity that commits money to an asset or venture with the expectation of generating a return on that investment. In the video, investors are mentioned alongside lenders as providers of capital. They look for assurance that they will get paid back, which influences the cost of capital they require for investing in a project.

💡Recession

A recession is a period of negative economic growth that lasts for at least two consecutive quarters. In the script, the last recession is used as a historical context to illustrate the consequences of an unsustainable cost of capital. During such times, properties may revert to lenders or investors if the cost of capital becomes too high for businesses to manage.

💡Wall Street

Wall Street is a street in New York City that is a symbol of the financial markets of the United States. In the video, Wall Street is mentioned as a source of abundant capital, indicating that the availability of funds is not the primary issue. Instead, the focus should be on securing capital at the lowest possible cost to ensure the success of business ventures.

Highlights

The concept of 'cost of capital' is introduced as a key financial metric encompassing all forms of money used in business.

Different types of funding, such as debt, equity, hard money, and mortgages, are all components of the cost of capital.

The cost of capital is crucial as it influences the overall expense structure of a business venture.

An example is given where a high-interest loan and a bank loan are blended, resulting in an estimated cost of capital of around six percent.

The cost of capital is an expense that reduces income, similar to insurance payments.

The availability of money is highlighted, with various institutions eager to lend, indicating a plentiful money market.

The importance of negotiating the lowest possible cost of capital to increase cash flow is emphasized.

The risk associated with a deal affects the cost of capital, with riskier deals commanding higher costs.

Lenders and investors prioritize the safety of their investment, seeking assurance of repayment.

The necessity of being cautious about the source and terms of funding due to its impact on the deal's feasibility is discussed.

A warning is issued about the potential for high cost of capital to negatively impact cash flow and the success of a deal.

The historical context of the last recession is mentioned, where inability to cover the cost of capital led to property repossession.

The transcript concludes with an encouragement for continued questions, indicating an open dialogue for further financial insights.

Transcripts

ken McIlroy here so now we're gonna talk

a little bit about money and lending and

debt and equity and things like that we

get a lot of questions around this I

think the best way to look at this it's

just to blend it all inside of one

phrase that's called the cost of capital

that's it so you can call it whatever

you want you can call it debt you call

it equity you call it hard money you

call mez you can call it you know all

kinds you can call it mortgages you can

call it all kinds of stuff but the end

of the day it's just money and it all

bundles in to what I call the cost of

capital that's the most important thing

that you need to consider okay

so for example let's say you're getting

money from somebody and it's your first

time out and it's a high interest loan

let's say eight ten percent and then you

go to a bank and you get something at

three or four or five percent

well that blended amount of money has

what's called a cost of capital probably

somewhere in the six percent range I

would guess when you blend the two

together because your equity is gonna be

less your debts gonna be more so the

combination of the two is your cost of

capital that cost of capital is

extremely important because it's an

expense of what it whatever it is you're

doing so if you're buying a franchise

that cost of capital wherever you get it

is it goes against your your income no

different than an insurance payment

instead in this particular case it's a

payment against the cost of capital so

when you're looking for money and money

is plentiful right now you got to pay

attention to the terms and the cost of

that money because it's gonna be all

over the map

and so when you're negotiating and you

can you have to make sure that you are

trying to get the lowest cost of capital

you can because if you lower your cost

of capital you're gonna increase your

cash flow so money is plentiful right

now there's more money than I've ever

seen ever

Wall Street's thrown it at you private

institutions are throwing it at you

institutions are throwing it at you

pension funds insurance companies banks

small banks big banks they all want to

lend right now in there and so act the

actual money itself is not

a problem if the deals good so in other

words you're always going to be able to

finance with that inequity a good deal

and what represents a good deal what

does the lender or an investor look for

they look for am I going to get paid

back that's all so if it's super risky

like a ground-up construction deal

there's gonna cost of capital might be

higher but if it's something that's

existing like an apartment building with

that's full there's gonna have less risk

and therefore your cost of capital

should be less and so there's different

kinds of things that represent risk from

an investor or a lender standpoint and

so as you're taking a look at your cost

of capital be very very cautious about

who you're taking it from and what the

cost of it is and what the terms are

because if you're if the deal is sound

you will find the money trust me and

then you need to negotiate the very best

thing but even on stuff that has a

little more risk to it you want to be

very very careful because the cost of

capital can kill the deal it can kill

the cash flow and you might never ever

be able to get out get out in front of

it and therefore that property will go

back to the lender or back to the

investor which is what we just saw there

in the last recession we saw people that

couldn't cover the cost of capital and

then the lenders take them back or their

bank owned or their investor owned so

that's what that means so great question

keep them coming and thank you

[Music]

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