Investment and consumption
Return on capital Introduction to return on capital and cost of capital. Using these concepts to decide where to invest.
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- Welcome to my presentation on return on capital
- Let's say we had return on capital
- Now I wanna do this presentation first because
- I think this is going to give you the big picture on how you need to think about
- what something is worth, whether you should invest your money into it,
- and how you should weigh the different options you had in terms of where you want it to point
- you want to put it in the bank, you want to put it in a house, do you want to pay off your credit cards, etc, etc
- so let's just define "return on capital", and just so you know
- I'm not neccessarily gonna be strict on the accounting conventions or the gap conventions
- I'm gonna do it more hands-on, how a "Joe investor" should
- think about their money. So, in this senario, I define "return on capital" as just
- the cash you get per year divided
- by the total cash you put in
- and well, I don't wanna just say cash. There's other ways to measure return
- but let's just keep it simple. let's just say cash
- so let's think about how this works out. let's say I have an idea, I have a restaurant
- and that restaurant will cost a million dollars
- of investment
- and let's say that per year, after paying all the expenses, after paying all the utilities
- after paying all the employees, after repairing and maintenance, after paying taxes
- this restaurant makes 100k per year.
- In this situation, my return on
- capital, the way I've defined it, is 100k divided by 1 million, or you could say 1000k,
- equals 10%. Pretty straight forward. You might be saying
- "Sal, this is silly, why are you wasting my time?" Well, maybe it is
- but I think you'll find that this going to lay a foundation that will eventually blow your mind
- so let's keep going.
- Okay, so I said the restaurant
- return on capital is equal to 10%. I could put
- a million dollars and I'll get in 100k per year
- now's that one project. and let's say I know for sure that I'm gonna,
- and I'm not gonna factor in things like risk just yet
- let's just say for sure i know that if i put my money here I'm gonna get 10% on my money
- and let's say the other option with my money is
- a beauty parlor
- and let's say that also costs 1 million dollars
- and this beauty parlor gets me 50k per year
- I think it's very obvious which investment you'd rather invest in
- because the return on capital on this beauty parlor is only 50k divided by a million
- or 5%. So this is obvious. you'd rather do the restaurant than the beauty parlor
- and in general you, after adjusting for risk, always wanna go
- with the project with the higher return on capital
- and later on there will be nuances in terms of when you get that return
- maybe you'd like a slightly lower return if you get the money faster
- or a slightly higher return if
- you're taking on risk or to compensate for risk
- So we know we want to do the restaurant but do we definitely want to do the restaurant?
- I mean we'd rather do the restaurant than the beauty parlor
- but my question to you is "Do we definitely want to do the restaurant?"
- and this is where the return on capital becomes interesting
- because what matters before we put the money into the restaurant is to think about
- what the cost of the money is to us
- and this is what I think will be a little bit of a new concept
- so I'm gonna introduce you now to the notion of a "cost of capital"
- so the restaurant costs a million dollars and it gets me
- 100k a year
- thats a 10% return on capital.
- let's say I have to borrow all the money and theres some bank that willing to give me
- all the money for this restaurant and the interest rate on this loan
- the interest rate is 15%
- is it still a good idea for me to open up a restaurant?
- Well, if I have a loan and I have to borrow the whole amount
- So I have a loan of a million dollars to buy that same restaurant
- and Im gonna be charged 15% in interest every year
- and I'm not gonna take taxes and the fact that you can deduct taxes etc etc
- into account just yet
- Let's just assume that my total cost is 15% per year in interest
- so I'm gonna have to spend 150k per year in interest
- So my question is "Does it still make sense for me to open up this restaurant?"
- every year im gonna be making 100k from the restaurant itself but im gonna be paying
- 150k a year in interest. you'll probably say "Sal, once again you've just restated the obvious
- no you would not want to do this restaurant
- because every year, 50k will be burning out of your pocket"
- Now you might think that this is obvious but I'm gonna show you many examples
- of where people are actively doing this
- people who you would otherwise assume could do this math and it's especially happening in the housing market
- but anyway in this situation you wouldn't want to invest it and a very simple way
- of thinking about this is you only want to invest, you only want to do a project, if your return on capital
- is greater than your cost of capital
- this is the only time that you want to invest in a project
- I just showed you something that we thought was obvious
- but I'm gonna re-ask you a question
- so we had the restaurant, we have the beauty parlor
- they both cost a million dollars
- the ROC of the restaurant is 10%
- and the ROC of the beauty parlor is 5%
- so right now, it looks like the restaurant is the better project
- but then we said the cost of capital, the interest rate
- which is how much does it cost us to get the million dollars
- the interest rate is 15%
- and we said that this is not a good investment
- because our cost of capital is greater than the return on capital
- but what if there was some kind of government program
- and they just felt that
- there werent enough beauty parlors in the country
- and they want to give you a really cheap loan to buy a beauty parlor
- and the government program said "We're gonna give you a low interest loan
- of 2%". so my question to you is "NOW which project would you rather do?"
- superficially, it looks like the restaurant is better. you get a 10% return as opposed to 5%
- but the cost of capital, the interest rate you'd have to pay on a loan for the beauty parlor
- suddenly looks a little bit better
- in fact this is actually a good investment
- because your cost of capital is less than your return on capital
- and we could be do the math
- every year the beauty parlor will generate
- 50k and you'll be paying 20k in interest
- so you'll be netting 30k without having to put any money for yourself
- you'll be borrowing all the money so clearly this is a good investment
- so thats it now for the intro on return on capital and cost of capital
- in my next presentations ill go a little bit more in detail
- and do a few more nuanced examples
Be specific, and indicate a time in the video:
At 5:31, how is the moon large enough to block the sun? Isn't the sun way larger?
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