What rate of return should an Indian company beat?.
Understanding why every rupee of capital has a cost, even your own.
Ramesh sat in his bakery, looking at a neat pile of cash. He had no bank loans, so he believed his profits belonged entirely to him. Yet, deep down, he felt his hard-earned savings should have earned more elsewhere. He was ignoring the silent cost of his own money.
Every business runs on two types of money. First is the owner's savings. Second is borrowed money from the bank.
Lenders demand interest on their loans. This cost is clear and written on paper.
But your own savings also have a cost. If you did not put that money in the business, you could have earned safe interest elsewhere.
Combining these two costs gives us the minimum return the business must earn. This hurdle rate is what we call the cost of capital.
Two shopkeepers and their funding choices
Think of two shopkeepers in the market. The first runs his shop entirely on his own savings. The second borrows half the money from a bank. The second shopkeeper pays a clear interest rate to the bank. Yet, both must make their shops generate enough profit to justify the money tied up in the business. If the first shopkeeper's returns are lower than what a simple bank deposit pays, his capital is dying. Every rupee of funding, whether borrowed or saved, has a hurdle it must cross.
Why this matters
When you buy shares of a company, you are a part-owner. If that company is earning a return on capital that is lower than its WACC, it is losing your money. It would be better off returning that cash to you so you can invest it elsewhere. Knowing a company's hurdle rate helps you avoid businesses that destroy wealth under the guise of growth.
Where people go wrong
- Using U.S. risk-free rates directlyIndian inflation and country risk are higher, requiring a much higher baseline rate.
- Treating equity as free capitalShareholders expect a premium over safe assets, which makes equity the costliest form of capital.
- Ignoring the tax shield on debtInterest payments are tax-deductible, reducing the actual net cost of debt for the company.
Every rupee of business capital has a cost, even the owner's savings.
Equity is always costlier than debt because shareholders bear the highest risk.
A business only creates true wealth when its return exceeds its WACC.
People suffer from visibility bias, obsessing over explicit interest payouts while treating equity as a free source of capital.