Sunday Brunch: The importance of the Cost of Capital - part 1

Sunday Brunch: The importance of the Cost of Capital - part 1

The Cost of Capital is a powerful financial concept, but one that hides a lot of complexity. The phrase is often mis-used. One common mistake is to believe that if a sustainability investment is lower risk, it means it's a better investment.

You cannot have your cake and eat it too - Ancient proverb

The Cost of Capital is a powerful financial concept, but one that hides a lot of complexity. The phrase is often mis-used. In fact I would argue it's probably the most misunderstood and most mis-used financial concept.

One common mistake is to believe that if a sustainability investment is lower risk, it means it's a better investment. I see this a lot in discussions about sustainable investments. Making your company more sustainable will lead to higher returns for your financial investors. And the mechanism for this is a lower cost of capital.

This is not just semantics. Using the concept incorrectly can mean that Sustainability Professionals lose creditability in discussions with their financial colleagues, and that really good sustainability projects don't get the consideration, and finance, they deserve. Too strong a focus on Cost of Capital as the lever to deliver more private capital takes attention away from other important factors such as cashflows and allocating risk.

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I want to be really clear here - I am not arguing that sustainable projects and companies do not make better investments. I think that often they do. It's just the mechanism by which this happens, in a financial sense, is not normally via the Cost of Capital.

Correctly understanding how the Cost of Capital concept should be applied can help you make better sustainable investing decisions. If you want to get more capital into sustainability focused projects, and hence make a real difference on the ground, it's a concept you need to understand.


How the cost of capital fits into the investment case process

A couple of weekends ago I wrote about the importance of a good narrative in creating an sustainability investment case that finance professionals can support. What the narrative gives you is a good foundation. And as an engineer turned banker I can confirm, without a good foundation, your building (or investment case) will fall over.

The same applies to the Cost of Capital. Properly applied it strengthens your financial case. Incorrectly used and you start off on the back foot.

Sunday Brunch: what is this investment worth?
How we create narratives to generate financial forecasts impacts the valuation process

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What is the Cost of Capital?

My simple working definition as an investor is it's:

the (expected) rate of financial return I need to earn to compensate me for the risks of investing in this project or company.

If the project is low risk, I am willing to accept a lower financial rate of return than if its high risk. Illustrating this with an example - I expect a lower rate of return from investing in (safer or lower risk) US government bonds, than I would if I invested in a (higher risk) speculative start up.

You may be asking at this point, what does this have to do with sustainability? As it turns out, rather a lot.

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