Understanding the cost of capital is critical for any company that is considering a large capital allocation decision such as an expansion, acquisition, or shareholder transaction. You can find the standard definition for cost of capital in any finance textbook. The general thinking is that you calculate a project’s expected Return on Invested Capital compared to its cost of capital to determine whether it has positive economics and is worth pursuing. The process seems relatively straightforward, right?
While this economic analysis is useful, there are a number of non-economic, qualitative factors that can make a private or family-owned company’s cost of capital exceedingly high, and arguably, they are not even measurable. They include things such as personal guarantees on debt or bonds, the effect on future generations of the family, the effect on employees and the community, and the legacy of the business. These factors, coupled with the fact that capital is scarce for private companies, make large capital allocation decisions much more difficult and deserving of far more scrutiny.
We call this the Cost of Being Wrong.
When a private or family company considers a large capital allocation decision, we feel that it is critical to be clear about the Cost of Being Wrong. Our definition of the Cost of Being Wrong is pretty simple – it is the cost to the business if the project fails. In defining it this way, we are not just talking about the math. We are talking about whether the level of the capital commitment is such that, if the project fails, it could permanently damage the business or possibly cause it to fail. Any project, no matter how appealing it may seem, should likely not be pursued if the cost of being wrong is that great.
Here is an example. Suppose a company has equity of $10M and it is considering two acquisition options. Option A is a $2M transaction. Option B is a $12M transaction. Without any more data, the cost of being wrong in option B far exceeds that of option A because of the size of the capital commitment in relation to the level of the company’s equity. Even if option B is the perfect acquisition, should you pursue it if it means you could lose the business if it does not work out? Conversely, if option A fails, it would hurt, but it would likely not kill the business. You could recover from it.
We have been involved in dozens of situations where we have helped clients evaluate capital allocation decisions. We have used this thought process in each case. You won’t find the Cost of Being Wrong in any finance textbook because it a unique, qualitative factor that affects every private and family-owned company in a different way. The analysis is driven by the high costs that are identified when all of the qualitative factors are taken into account, coupled with the fact that capital is scarce.
Understanding the Cost of Being Wrong is part of our playbook in advising clients, and we suggest that you make it part of your analysis when facing large capital allocation decisions.
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