Learn about Return on capital Video

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Learn about Return on capital

Welcome to my presentation on return on capital. Let me write that down. Oh, I’m using the wrong color. Let me use a nicer color. Let me go to white. Return on Capital, I want to do this presentation first because I think this is really going to give you the big picture on how you should think about what something is worth, whether you should invest your money into it and how you should weigh the different options you have in terms of what you have to do with your money in terms of where you wanted to play. You want to play in the bank, you want to buy a house, you want to pay off your credit cards, etc, etc. So let’s just define what a return in capital or just so you know I’m not necessarily going to be stripped on the county convention or the gap convention, that’s the kind of convention in this country. I'm going to do it more on a hands on how Joe investor should think about their money. So in this scenario, I define return on capital as just the cash you get per year divided by the cash, the total cash you put in. and well I don’t want to just say cash, we could say, there’s other ways to measure return. But actually let’s just keep it simple, let’s just say cash. So let’s think about how this works out. Let’s say I have an idea. I have a restaurant. And that restaurant, that will cost a million dollars. It will cost $1 million investment in this restaurant. Let’s say that per year after paying all the expenses, after paying the utility, after paying the employees, after repairing and maintenance, and after paying taxes, everything. Let’s say this restaurant makes $100,000 a year. That’s after taxes. That’s what goes into my pocket. So in this situation, my return on capital the way I defined it is $100,000 divided by 1 million or you could say a thousand thousand dollars or equals 10%. Pretty straight forward. You’re probably saying, Sal this is silly, why are you wasting my time. Well, maybe it is but I think you’ll find that this is going to lay a foundation that will eventually blow your mind. So let’s keep going. Let me do another, okay. So I said the restaurant, let’s say it’s a pizza restaurant. So let’s just say the restaurant return on capital is equal to 10%. I could put a million dollars and I’ll get in a hundred thousand dollars every year. That’s where I got a 10%, let me write that down. I get a hundred thousand per year out of 1 million investment. Now that’s one project. And let’s just say I know for sure that I'm not going to factor in things like risk and probably this just yet. Let’s just say for sure, I know that if I put my money here, I'm going to get 10% on my money. And let’s say the other option with my money is a beauty parlor. Now let’s say that that also cost $1 million. Well and this beauty parlor gets me $50,000 a year. I think it’s very obvious to you already how which investment you’d rather invest in. because this, the return on capital on this beauty parlor is only 50,000 divided by a million or 5%. So this is obvious. You’d rather do the restaurant than a beauty parlor. In general, if you after adjusting for risk, you always want to go with the project that has the higher return on capital. And later on, there’ll be new ones in terms of when you get that return, maybe you’d like or rather have a slightly low return if you get the money faster Or a slightly higher return if you’re taking on risk, etc, etc. or to competent for risk. So we know we wanted the restaurant but do we definitely want to do the restaurant? I mean we’d rather do the restaurant than the beauty parlor. But my question to you is do we definitely want to do the restaurant? And this is where the return on capital becomes interesting. Because what matters before we put the money in the restaurant is to think about what the cost of that money is to us. And this is why I think will be a little bit of a new concept to you. So I'm going to introduce you now to the notion of a cost accounting. So let me erase this. So the restaurant cost a million dollars and it gets me $100,000 a year and that’s a 10% return on capital. Now let’s say I have to borrow all the money and there are some banks that’s willing to give me all the money for this restaurant. And the interest rate on this loan is, let’s say it’s a loan, the interest rate is 15%. Is it still a good idea for me to open up the restaurant? Well, if I have a loan and I have to borrow the whole amount. So I'm going to have a loan for $1,000,000 to buy that same restaurant and I'm going to be charged 15% in interest every year and I'm not going to take taxes and the fact that you could deduct taxes, etc, etc and to count just yet. Let’s assume that my total cost is 15% per year in interest. So I'm going to have to spend $150,000 per year in interest. So my question to you is, does it still make sense for me to open up this restaurant. Every year I'm going to be making $100,000 from the restaurant itself but I'm going to be paying $150,000 a year in interest. You’re probably saying, Sal once again you have restated the obvious, no you would not want to do this restaurant. Because every year $50,000 will be burning out of your pocket. You might think that this is obvious but I'm going to show you many, many examples of where people are actively doing this, people who you would otherwise assume could do this type of math. And it’s especially happening in the housing market. But anyway, so in this situation, you would want invest it and the very simple way of thinking about this is you would only want to invest, you only want to do a project if your return on capital is greater than your cost of capital. This is the only time that you want to invest in a project. But that’s it. I'm not going to go back to what we just did. I just showed you something we thought was obvious but I'm going to re-ask you a question. So we had the restaurant and we have the beauty parlor, we call it BP for short. They both cost $1,000,000. The ROC of the restaurant we said was 10% and the ROC of the beauty parlor we said was 5%. So right now, superficially it looks like the restaurant is just a better project. But then we said the cost of capital, so the interest rate which is our, how much did it cost for us to get that million dollars, the interest rate to borrow money for our restaurant is 15%. Now we said that this is not a good investment because our cost of capital is higher than our return on capital. You could do the math and figure it out. But what if there is some kind of government program that they just felt that there weren’t enough beauty parlors in the country and they are willing to give you a really cheap loan to buy a beauty parlor. And the government program, they said we’re going to give you a low interest loan of 2%. So my question to you is, now which project would you rather do? Superficially, it looks like the restaurant was better, you get a 10% return as oppose to 5% but your cost of capital, the interest rate you would have to pay on a loan for the beauty parlor all of a sudden looks a little bit better. In fact this is actually a good investment because your cost of capital is less than your return on capital. You could even do the math. Every year the beauty parlor will generate $50,000 and you’ll be paying $20,000 in interest. So you’ll be netting $30,000 without having to put any money for yourself. You will be borrowing all of the money. So clearly this is good investment. So that’s it now for the intro on return on capital and cost of capital. And my next presentation, I’ll go a little bit more detail and do for you more new ones example.

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Welcome to my presentation on return on capital. Let me write that down. Oh, I’m using the wrong color. Let me use a nicer color. Let me go to white. Return on Capital, I want to do this presentation first because I think this is really going to give you the big picture on how you should think about what something is worth, whether you should invest your money into it and how you should weigh the different options you have in terms of what you have to do with your money in terms of where you wanted to play. You want to play in the bank, you want to buy a house, you want to pay off your credit cards, etc, etc.

So let’s just define what a return in capital or just so you know I’m not necessarily going to be stripped on the county convention or the gap convention, that’s the kind of convention in this country. I'm going to do it more on a hands on how Joe investor should think about their money. So in this scenario, I define return on capital as just the cash you get per year divided by the cash, the total cash you put in. and well I don’t want to just say cash, we could say, there’s other ways to measure return. But actually let’s just keep it simple, let’s just say cash.

So let’s think about how this works out. Let’s say I have an idea. I have a restaurant. And that restaurant, that will cost a million dollars. It will cost $1 million investment in this restaurant. Let’s say that per year after paying all the expenses, after paying the utility, after paying the employees, after repairing and maintenance, and after paying taxes, everything. Let’s say this restaurant makes $100,000 a year. That’s after taxes. That’s what goes into my pocket. So in this situation, my return on capital the way I defined it is $100,000 divided by 1 million or you could say a thousand thousand dollars or equals 10%. Pretty straight forward. You’re probably saying, Sal this is silly, why are you wasting my time. Well, maybe it is but I think you’ll find that this is going to lay a foundation that will eventually blow your mind.

So let’s keep going. Let me do another, okay. So I said the restaurant, let’s say it’s a pizza restaurant. So let’s just say the restaurant return on capital is equal to 10%. I could put a million dollars and I’ll get in a hundred thousand dollars every year. That’s where I got a 10%, let me write that down. I get a hundred thousand per year out of 1 million investment. Now that’s one project. And let’s just say I know for sure that I'm not going to factor in things like risk and probably this just yet. Let’s just say for sure, I know that if I put my money here, I'm going to get 10% on my money.

And let’s say the other option with my money is a beauty parlor. Now let’s say that that also cost $1 million. Well and this beauty parlor gets me $50,000 a year. I think it’s very obvious to you already how which investment you’d rather invest in. because this, the return on capital on this beauty parlor is only 50,000 divided by a million or 5%. So this is obvious. You’d rather do the restaurant than a beauty parlor. In general, if you after adjusting for risk, you always want to go with the project that has the higher return on capital. And later on, there’ll be new ones in terms of when you get that return, maybe you’d like or rather have a slightly low return if you get the money faster Or a slightly higher return if you’re taking on risk, etc, etc. or to competent for risk.

So we know we wanted the restaurant but do we definitely want to do the restaurant? I mean we’d rather do the restaurant than the beauty parlor. But my question to you is do we definitely want to do the restaurant? And this is where the return on capital becomes interesting. Because what matters before we put the money in the restaurant is to think about what the cost of that money is to us. And this is why I think will be a little bit of a new concept to you.

So I'm going to introduce you now to the notion of a cost accounting. So let me erase this. So the restaurant cost a million dollars and it gets me $100,000 a year and that’s a 10% return on capital. Now let’s say I have to borrow all the money and there are some banks that’s willing to give me all the money for this restaurant. And the interest rate on this loan is, let’s say it’s a loan, the interest rate is 15%. Is it still a good idea for me to open up the restaurant? Well, if I have a loan and I have to borrow the whole amount. So I'm going to have a loan for $1,000,000 to buy that same restaurant and I'm going to be charged 15% in interest every year and I'm not going to take taxes and the fact that you could deduct taxes, etc, etc and to count just yet. Let’s assume that my total cost is 15% per year in interest. So I'm going to have to spend $150,000 per year in interest. So my question to you is, does it still make sense for me to open up this restaurant. Every year I'm going to be making $100,000 from the restaurant itself but I'm going to be paying $150,000 a year in interest. You’re probably saying, Sal once again you have restated the obvious, no you would not want to do this restaurant. Because every year $50,000 will be burning out of your pocket. You might think that this is obvious but I'm going to show you many, many examples of where people are actively doing this, people who you would otherwise assume could do this type of math. And it’s especially happening in the housing market.

But anyway, so in this situation, you would want invest it and the very simple way of thinking about this is you would only want to invest, you only want to do a project if your return on capital is greater than your cost of capital. This is the only time that you want to invest in a project. But that’s it. I'm not going to go back to what we just did. I just showed you something we thought was obvious but I'm going to re-ask you a question.

So we had the restaurant and we have the beauty parlor, we call it BP for short. They both cost $1,000,000. The ROC of the restaurant we said was 10% and the ROC of the beauty parlor we said was 5%. So right now, superficially it looks like the restaurant is just a better project. But then we said the cost of capital, so the interest rate which is our, how much did it cost for us to get that million dollars, the interest rate to borrow money for our restaurant is 15%. Now we said that this is not a good investment because our cost of capital is higher than our return on capital. You could do the math and figure it out. But what if there is some kind of government program that they just felt that there weren’t enough beauty parlors in the country and they are willing to give you a really cheap loan to buy a beauty parlor. And the government program, they said we’re going to give you a low interest loan of 2%. So my question to you is, now which project would you rather do? Superficially, it looks like the restaurant was better, you get a 10% return as oppose to 5% but your cost of capital, the interest rate you would have to pay on a loan for the beauty parlor all of a sudden looks a little bit better. In fact this is actually a good investment because your cost of capital is less than your return on capital. You could even do the math. Every year the beauty parlor will generate $50,000 and you’ll be paying $20,000 in interest. So you’ll be netting $30,000 without having to put any money for yourself. You will be borrowing all of the money. So clearly this is good investment.

So that’s it now for the intro on return on capital and cost of capital. And my next presentation, I’ll go a little bit more detail and do for you more new ones example.

Transcription by: Scribe4you Transcription Services