Overview of Risk and Return, Time Value of Money, Cost of Capital
To date we have examined the role that financial statements - especially pro forma statements - play in mapping out the future course for a company. Before we start talking about the key decision issues at the corporate level, however, we still need to learn about one more set of tools; risk and return, the time value of money, and cost of capital.
Risk and Return
Risk and return are the back bone of finance. Without them, it is impossible to make any rational business decision. Return in its simplest form can be defined as income (or better, net cash inflow) divided by investment. For example, if you buy a house for $100,000 and sell it for $110,000 a year later, your one-year return is 10,000 divided by 100,000 or 10%. We can more or less use the same concept to calculate multi-period returns. We also have the Capital Asset Pricing Model (CAPM) at our disposal for calculating required rates of returns.
Risk, however, needs more explanation. In finance, risk can be discussed both at the corporate level and investment level. For corporations, there are two types of risk; business and financial. For investors, there is only portfolio risk. Business or operating risk has to do with the use of fixed assets by a firm. The more fixed assets a company has in its possession, the more its operating risks. Financial risk has to do with the use of debt by a company; the more debt, the higher the financial risk. The reason for this is simple. In times of economic downturn, companies experience difficulty paying their fixed commitments such as interest or fixed operating costs. This places the company's continuing operation in jeopardy. Portfolio risk on the other hand, also called beta, occurs when we consider investments by either individuals or institutions. Beta is, is in fact, a key component of the CAPM.
Time Value of Money
The basic principle of the time value of money (TVM) is that a dollar received today is worth more than a dollar received tomorrow. The reason for this is the opportunity cost of money - or interest rate. In other words, one could invest an amount today and start collecting interest as time goes on. TVM, closely related to the concept of risk and return, allows us to get a clear sense of financial trade-offs involved in any form of financial transaction such as long-term corporate investments (capital budgeting) at the business level or home loan mortgages at the individual level.
Cost of Capital
Capital is referred to as the right-hand side of the balance sheet - mainly the sum of liability and equity. Cost of capital (COC) is the cost of financing a company’s operations or assets - the left-hand side of the balance sheet. Furthermore, COC is the minimum rate of return that a company’s owners (stockholders) require. If the minimum rate is not achieved by a firm, then the owners will divest their money and invest elsewhere, driving that company’s stock price down and placing the future of the company at risk. In other words, COC is a cost item to companies, and a return item to investors - including bondholders.
