If you’re in the world of business and finance, you surely must’ve come across the term Cost of Capital. Perhaps, even calculated it many a time for making purchase and investment decisions in your business.
But for those of you who aren’t aware of the term,
What is Cost of Capital?
Say you’ve got an idea for a new product, or a way to revamp some existing vertical or function within your organisation; something that’ll bring more efficiency to the company.
But before you spend the company’s hard-earned money, you’ve got to prove to your company’s leaders that it’s worth the investment. You’ll likely be asked to show that the return on the investment will be better than your company’s cost of capital, i.e., the rate of interest at which your company acquires the capital to deploy it.
Let's say your Cost of Capital is 12% and the RoI you're expecting from the new installation is 15%. Then, the investment probably makes sense for you. But if say your cost of capital is 18%. Then, the same investment will not make sense for you anymore as it doesn't reap RoI > 18%.
Cost of Capital calculation in the real world usually also involves concepts like discount rate, opportunity cost, and other tax considerations. However, we won't be covering them in this post.
But essentially, if you can get capital at a lower rate of interest or at a lower cost, you have a competitive advantage over other businesses.
This is the primary second-order effect of cost of capital and why it matters.
Cost of Capital is different for different people and organisations. And in a world where investment decisions compound, these differences in the cost of capital can lead to vastly unequal outcomes in the long term.
If you have two people, and one can get a loan at 8% interest rate and the other can only get it at 12%, the 4% difference can compound over the years and lead to huge inequality in outcomes down the line.
In fact, cost of capital also has higher-order effects on a societal level. In India, You can get:
- Education Loans at 13-15%
- Personal/Car loans for salaried ppl at 7-8%
- Corporate bonds at 7-10%
- but microfinance for small businesses at 16-20%!!!
Over time, higher interest rates for small business owners only disincentivizes entrepreneurship and forces people from poor backgrounds to go into employment, as they cannot afford the cost of capital.
This is where I think startups like CRED can really make a difference:
By using credit scores and trust as an indicator of financial responsibility, they can lower the cost of capital for deserving individuals.
CRED can use a person's credit history as a proxy for their trustworthiness and then offer them capital at interest rates that are much lower than the conventional banks.
Finally, it all comes down to their underwriting process.
When you're offering collateral-free loans to customers with only a few finger taps on a smartphone screen, the accuracy of your underwriting process becomes critical. In general, any lending product's competitive advantage finally boils down to underwriting: how they use data to measure credit risk and disburse loans to people who they can say, with a high level of certainty, will pay back those loans.
If a lending business' underwriting process is weak, they may disburse a lot of bad loans that do not get repaid. Hence, any bet you place on a lending product is essentially betting on their underwriting process and how good it is.
The Indian society is low on trust, and that is why in matters of money, trust and relationships are valued very highly. You can't build trust in a day. And you can't build trust with people who you don't know.
Think of CRED as an intermediary for establishing trust between two individuals — the lender and the borrower — who don't know each other but would still transact with each other with their CRED as a proxy for their trustworthiness. Conventionally, banks have always done this. Now CRED is trying to do this with vastly better technology and adding a huge element of convenience and design to the whole process.
Building credibility in a community of trustworthy individuals means you may be able to avail yourself capital at a much cheaper cost than others, along with many benefits you might be privy to — say being first in line for getting a house on rent or getting an international travel visa.
As they often say, good people need to be rewarded. And although these rewards today can come in the form of cashbacks and discounts, the real reward in being a part of CRED lies in your enhanced ability to procure capital at cheaper rates in the future.