During my stint as an investor, once the CFO of an Indian conglomerate came to our office with his team. They were looking for funding since their businesses were not doing very well.
During the discussion, just to see how clear their thinking was, I asked the CFO, “What is your cost of equity?”
He said, “25%.”
When I asked him to explain, he said, “We pay 25% dividend.”
While it was shocking to see a CFO being so uninformed, I could empathize that the terms like ‘cost of equity’ or ‘cost of capital’ are not very intuitive.
In fact, when I first heard these terms during my MBA, it all sounded very technical – I knew how to derive them using CAPM but did not really understand what they meant.
Those days, if you had asked me whether the cost of capital was the same for an American vs. a North Korean investor, I would have run away.
But much later, it struck me that when we say ‘cost’, we mean ‘opportunity cost.’ As simple as it was, that aha moment clarified everything.
‘Cost of equity’ of a company ‘A’ is what the investor would have earned by investing in another similar company. But by investing in ‘A’, he is giving up that alternative return – hence, that is the opportunity cost.
So a North Korean who can’t put his money to good use, has a very lost cost of capital – whatever he can earn locally. But if he can smuggle his money out and invest on the Shanghai stock exchange, his opportunity cost goes up! His cost of capital has now changed.
True understanding = Intuition.
Jargon is best used to confuse others (and oneself).