Finance and capital markets
Introduction to return on capital and cost of capital. Using these concepts to decide where to invest. Created by Sal Khan.
Welcome to my presentation on return on capital. Let me write that down. I'm using the wrong color. Let me use a nicer color. Let me go to white. I want to do this presentation first, because I think this is really going to give you the big picture on how you should think about what something is worth. Whether you should invest your money into it. And how you should weigh the different options you have in terms of what you actually have to do with your money, in terms of where you want to put it. Do you want to put it in the bank? Do you want to buy a house? Do you want to pay off your credit cards? Et cetera, et cetera. So let's just define return on capital. And just so you know, I'm not necessarily going to be strict on the accounting conventions, or the GAP conventions -- that's the accounting conventions in this country. I'm going to do it more on a hands-on, how Joe Investors should think about their money. So in this scenario, 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 want to just say, cash. There's other ways to measure return. But actually, to 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, it'll cost $1 million. It'll cost $1 million investment in this restaurant. It's going to be a $1 million investment. And let's say that, per year, after paying all the expenses, after paying the utility, after paying the employees, after repairing, and maintenance, and after paying taxes, everything, let's say this restaurant makes $100,000 a year. And that's after taxes and everything. That's what goes into my pocket. So in this situation, my return on capital, the way I've defined it, is $100,000 divided by $1 million, or we could just say a thousand thousand dollars, equals 10%. Pretty straightforward. You're probably saying, Sal, this is silly. Why are you wasting my time? Well, maybe it is. But I think you'll find that this is going to lay a foundation that will eventually blow your mind. So let's keep going. Let me do another. OK, so I said the restaurant -- let's make it a pizza restaurant -- let's just say, the restaurant return on capital is equal to 10%. Right? I can put in $1 million and I'll get in $100,000 per year. That's where I got 10%. Let me write that down. I get $100,000 per year off of $1 million investment. Now, that's one project. I'm not going to factor in things like risk and probabilities just yet. Let's just say, for sure, I know that if I put my money here, I'm going to get 10% on my money. And let's say the other option with my money is a beauty parlor. And let's say that that also costs $1 million. And this beauty parlor gets me $50,000 a year. I think it's very obvious to you already which investment you'd rather invest in. Because the return on capital on this beauty parlor is only 50,000 divided by a million, or 5%. So this is obvious. You'd rather do the restaurant than a beauty parlor. And in general, after adjusting for risk, you always want to go with the project that has the higher return on capital. And, later on, there will be nuances in terms of when you get that return. Maybe you would rather have a slightly lower return if you get the money faster. Or a slightly higher return if you're taking on risks, et cetera, et cetera. Or to compensate for risk. So we know we want to do the restaurant. But do we definitely want to do the restaurant? We'd rather do the restaurant than the beauty parlor, right? 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 that money is to us. And this is what I think will be a little bit of a new concept to you. So I'm going to introduce you, now, to the notion of a cost of capital. So let me erase this. OK. So the restaurant costs $1 million. And it gives me $100,000 a year. And that's a 10% return on capital. Now, let's say I have to borrow all the money. And there's some bank that's willing to give me all the money for this restaurant. And the interest rate on this loan is, let's say, 15%. Is it still a good idea for me to open up the restaurant? Well, if I have a loan and I have to borrow the whole amount -- so I'm going to have a loan for $1 million to buy that same restaurant. And I'm going to be charged 15% in interest every year . And I'm not going to take taxes, and the fact that you could deduct taxes, et cetera, et cetera , into account just yet. Let's assume that my total cost is 15% per year in interest. So I'm going to have to spend $150,000 per year in interest. So my question to you is, does it still make sense for me to open up this restaurant? Every year, I'm going to be making $100,000 from the restaurant itself. But I'm going to be paying $150,000 a year in interest. So you'll probably say, Sal, once again, you have just restated the obvious. No, you would not want to do this restaurant. Because every year, $50,000 will be burning out of your pocket. Now, you might think that this is obvious, but I'm going to show you many, many examples of where people are actively doing this. People who you would otherwise assume could do this type of math. And it's especially happening in the housing market. But anyway. So in this situation, you wouldn't want to invest in it. And a very simple way of thinking about this is you'd 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. With that said, I'm not going to go back to what we just did. I just showed you something that we thought was obvious, but I'm going to re-ask you a question. So we had the restaurant. And we have the beauty parlor. Let's call it BP for short. They both cost $1 million. Let me write ROC. The ROC of the restaurant, we said, was 10%. And the ROC on the beauty parlor, we said, was 5%. So right now, superficially, it looks like the restaurant is just a better project. But then we said the cost of capital, so the interest rate. How much does it cost for us to get that $1 million? The interest rate to borrow money for a restaurant is 15%. And we said that this is not a good investment. Because our cost of capital is higher than our return on capital. And you could do the math and figure it out. But what if there was some kind of government program? They just felt that there weren't enough beauty parlors in the country. And they were willing to give you a really cheap loan to buy a beauty parlor. And the government program, they said, we're going to 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 was better. You get a 10% return, as opposed to 5%. But your cost of capital, the interest rate you would have to pay on a loan for the beauty parlor, all of a sudden 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. We can even do the math. Every year the beauty parlor will generate $50,000. And you'll be paying $20,000 in interest. So you'll be netting $30,000 without having to put any money for yourself. You'll be borrowing all the money. So clearly this is a good investment. So that's it, now, for the intro on return on capital and cost of capital. And in my next presentations, I'll go into a little bit more detail and do a few more nuanced examples.