What’s Your Cost of Capital?
Cost of capital is a concept that (1) is near and dear to my heart and (2) gets a bad rap for being abstract when in fact it’s probably the foundation for every disagreement people have with one another. For example, if you and your significant other want to leave at different times to drive somewhere because one of you expects traffic and the other doesn’t and would prefer more time to pack, that's cost of capital.
Don’t believe me? Your time is your capital and your opportunity cost and traffic are your risks, so you are both backing into different fair values of departure times based on different acceptable margins for error. And God help you if you end up being the wrong one...
Or let’s say you bought a lottery ticket with a billion dollar jackpot picking the numbers that are your grandkids’ birthdays because you had a feeling that there was a really good chance you would win. Then let’s say a stranger came up to you and offered to buy your ticket for less than you paid for it, but more than zero. Mathematically, it would be a no-brainer for you to take that offer because lottery tickets have negative expected value. Once you bought one, getting anything more than zero would be a win!
But the reason you bought it is because you had a feeling, and if it’s a billion-dollar jackpot, think about what you might sell that ticket for. $100? $100k? $1M?
This is the reason game shows like Let’s Make a Deal, Who Wants to Be a Millionaire, and Deal or No Deal work. Because there’s tension when counterparties assess odds and values differently. Again, that’s the cost of capital.
See, we’re all fair-valuing everything all of the time and transacting when we think it suits us. This means we mostly try to buy things that we think are undervalued and sell things that we think are overvalued, except when we find ourselves in times of distress, i.e. there’s a need for immediate action. But leaving aside those times when we put ourselves in a pickle, there is an academic definition of this. Cost of capital equals the risk-free rate plus volatility times the return one expects to get for taking risk in excess of no risk.
But here’s how I’d put it in layman's terms…
Your “cost of capital” is what you can do by just getting out of bed plus your probability of doing something great times the magnitude of that greatness.
Knowing that, if you struggle to reach agreements with people, it should prompt consideration of all of those variables…and also of what you decide to do this weekend. Have a great one.
– By Tim Hanson