Understanding Cost of Capital – Michael Pittman

Outside of starting a consulting firm, starting any sort of business within the sustainability of renewable energy field will be highly capital intensive. To start a renewable energy business you must have the working capital or credit to finance the high startup costs. Many firms will take on investors to help with startup costs. These investors will have certain needs, most specifically “Will this venture offer me a good return on my investment?” What are the chances that the risk of the investment will result in a large enough reward? If there is a positive return, will the return be greater than investing in equities or sitting on my cash for the next best opportunity?

The three most common ratio’s used to determine the returns a company generates are return on assets (ROA), return on equity (ROE), and return on invested capital (ROIC) (Khan 2014). ROA is calculated by taking net income and dividing by net assets. This can be skewed very easily by a firm that holds on to excess assets or cash. ROE is calculated by net income divided by shareholder equity. This provides the level of profitability that is achieved from money provided to the firm by investors. This number can also be skewed because it does not take into account any preferred shares that the firm may have issued. ROIC is calculated by taking net operating profit after taxes divided by invested capital. This would let investors know how well the business turned invested capital into profits.

Each one of these ratio’s is important because knowing all three will offer a much better understanding of a firm and its financial position. Investors need to know that you will be able to offer them solid performance under each metric and return on their investment.

A factor that for some reason that is always overlook and should be an important part of any investment discussion is “How good are you at sales?” You can have the best product. You can have the most efficient operations side of the business. You can have the best and brightest talent working for you. You can be a part of the newest and fasted growing market segment in business. None of these matter if you cannot sell your product. As an investor, I would need to have extreme confidence in the entrepreneur’s ability to sell or confidence that he could employ a strong sales force before I would invest.

 

 

 

 

 

 

Khan, Saliq. “ROA vs. ROE vs. ROIC .” The Johns Hopkins Carey Business School Equity Analyst Team . Johns Hopkins Carey Business School, 9 July 2011. Web. 21 Oct. 2014. <http://jhuanalystteam.blogspot.com/2011/07/roa-vs-roe-vs-roic.html>.

One thought on “Understanding Cost of Capital – Michael Pittman

  1. Hello Michael,
    I really enjoyed reading your post! You are correct that investors are really only interested if they make a profit. Being an investor would be risky, however. Like you said, they could miss out on a better opportunity if they put their money into a different project. You are also correct that the most important thing is you have to be able to sell your product. Like I said in my posting, an investor has to like the business idea, product, and the person asking for the funding. If they cannot trust the business leader to sell the product, etc. – they would not have a good business relationship. If you would like to read my post, here is the link:
    http://engr312.dutton.psu.edu/2014/10/21/lesson-8-bethany-steiner/

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