A Capital Development, My Good Man

Prior to today, I was lost regarding cost of capital. Especially cost of equity capital. That concept just made no sense to me. Luckily, I know tolerant private equity folks. One in particular - let's call him John - graciously indulged me in the email exchange below. Since I answered his last question correctly, I'm optimistic that I might someday thoroughly understand this concept. Anyway, to: (1) expose my tender, ignorant underbelly; and (2) help those of you fans who are similarly disadvantaged at these matters of high finance, the exchange is set forth below in its entirety.

• From: John
  To: Garrett
  Sent: Monday, July 18, 2005, 13:13
  
  And with that we move to lunch.
  
  
• From: Garrett
  To: John
  Sent: Monday, July 18, 2005, 13:10
  
  $76.92?
  
  
• From: John
  To: Garrett
  Sent: Monday, July 18, 2005, 13:07
  
  Yes. Now for the missing link. I am selling a $100 bill and will deliver in 1 year. How much will your hypothetical company below pay for that asset? How much would someone with a 30% equity return (and $0 debt) expect to pay?
  
  
• From: Garrett
  To: John
  Sent: Monday, July 18, 2005, 13:02
  
  Because you like me? That's a joke. Inappropriate one too, as on further reflection I think I'm starting to appreciate why your question is intelligent. But obviously gobs of people do give companies money and then the companies generate a lower return than US Treasuries. Of course, that fact is not relevant to a calculation of the cost of equity capital. How about this - one thing that flummoxes me about it is that today, I can make a pretty good prediction how much "debt" is going to cost a company I'm looking at. I can calculate their interest expense and make assumptions about whether they'll pay off principal or borrow more money, etc. But of course I can't make many accurate predictions about what equity investors are going to do, how much they'll want to charge the company for the capital they contribute to it.
  
  Is that right?
  
  OK, so now I feel like with cost of equity, I have to look back. I have to say, well, historically, people have expected a 10% return on their equity capital from this company. Oh wait ... maybe I'm getting there. So then I can also say that, well, I can see from the balance sheet/income statement that it's going to cost this company 6.5% for their debt capital. And from those two pieces of information I can make assumptions about whether the investment is sound? I'm still missing something.
  
  I also haven't slept much in a week, so if you've wearied of this for today, by all means let me know and we can table it for another lunch discussion.
  
  
• From: John
  To: Garrett
  Sent: Monday, July 18, 2005, 13:00
  
  Close. Perhaps a question helps. Question: If I can put my money in a US backed treasury and earn 8% a year, why would I give you money if your intentions are only to increase my stock 5% per year?
  
• From: Garrett
  To: John
  Sent: Monday, July 18, 2005, 12:44
  
  OK. I feel like I'm getting closer, then. So if someone says to me that XYZ Corp. has a "cost of equity capital" of 15%, are they really looking at the amount of equity capital contributed to the company historically and comparing that to the profits of the business or earnings allocated to the equity holders or something like that?
  
  
• From: John
  To: Garrett
  Sent: Monday, July 18, 2005, 11:51
  
  Nope. You are right on. Its very vague. Just always remember your equity shareholders want a return too. IE) in the MLP scenario, they demand anywhere from 4% (coal) to 15% (levered pipelines).
  
  
• From: Garrett
  To: John
  Sent: Monday, July 18, 2005, 11:33
  
  That is almost helpful! Ha ha. One of the things I guess I'm struggling with about is that I'm thinking returns to equity are generally less predictable (or maybe it's just less easy to quantify) than returns on debt. Does that make sense? I mean my brain can totally understand debt. I loan you $100. You pay me back $110 sometime later. The return to me, the lender, is clear. The cost to you, the borrower, is also. Now if I contribute $100 to you as equity, I've got an expectation about what I want the return to be, but you haven't promised me any return. Am I an idiot?

• From: John
  To: Garrett
  Sent: Monday, July 18, 2005, 9:54
  
  The equity portion can be quite complex formulaically. Beta, risk capital, treasury etc. I'd have to look it up to get it right. The easiest way to think about cost of equity is in third party terms. If I lent you $50,000 for a down payment on a car and the bank loaned you $100,000 (we'll use a Ferrari as the picture in our heads, think big right!?!). The bank would charge a rate of interest, say 7% and I would charge you interest or have some sort of kicker. We charge 10% before management begins to back into any sort of promoted ownership. Our target retrun is 25% thought so in models, if that's what we want to achieve on our equity, our equity component needs to represent 25%.
  
  25% * .333 + 7% * .667 = 12.9%.
  
  Every project we look at now needs to return at least 12.9% annually to get me my 25% and pay the bank its 7%.
  
  
• From: Garrett
  To: John
  Sent: Sunday, July 17, 2005, 22:13
  
  OK - next remedial finance question is can you explain cost of capital to me? I can understand how the cost of debt capital is determined. That makes sense to me. But I can't get my head around how the cost of equity capital is determined. Maybe if you could put it into terms of a person's just general personal life it would make sense to me. Any help you can give in this regard would be greatly appreciated.