Cost of Funds
Your grandmother gives you $500 on your birthday. Since you’re her special, thrifty little fella or lady, you put that cash into a savings account that pays you 2% a year. Assuming you don’t touch that money, you’ll have $510 at the end of the year (thanks, Federal Reserve) due to interest.
That $10 you earned in interest is an expense to the bank. An expense called “cost of funds.”
Add up all the interest paid by a bank for the money that they pay to depositors on different accounts, and you receive an aggregate cost of funds for the entire financial institution.
Cost of funds is a key expense on which investors and companies measure the performance of a bank. Banks make money on loans to customers and business. Banks charge them interest for that capital. So if the bank loans out $400 and charges 5% to its customer (keeping $100 in reserves), it will effectively earn $22.50 in charges if the lendee doesn’t pay back any of the principal.
In this case, the bank lent money out and earned $22.50, but paid you $10 in interest. The $12.50 difference is known as the net interest spread. That amount is money that the bank could generate thanks to its deposit and lending operations.
See: WACC.
Related or Semi-related Video
Finance: How do you assess the cost of e...11 Views
finance a la shmoop how do you assess the cost of equity
all right so people remember that's equity that's your stock that's the [Man driving a car]
ownership of the company trying to figure out how you assess the cost of it
when you do stuff with it okay so your specific motors your like [Specific motors store]
General Motors but your products way less vague with your stock at $20 a
share and fifty million shares outstanding Wall Street is telling you
when they're paying 20 bucks a share for your stock that specific motors is worth
a cool billion dollars got it 20 times 50 there you want to buy your dreaded
hated competitor Alfalfa Romeo for two hundred million dollars yep [Plane carrying Alfalfa Romeo banner]
the one started by the little rascal that one so you've gotten your board to
agree to let you make this transaction and you've gotten Alfalfa Romeo to agree [Specific Motors and Alfalfa Romeo board in a meeting]
to it as well the only question now is how you pay for this transaction that is
how you pay the two hundred million dollars is it in cash or is it in stock
all right well you could borrow the money and if you do the rate of interest
you'll pay is seven percent with terms already set so that you have to pay back
one tenth of the loan each year for ten years until it's all paid off got it so
two hundred million dollars that is 20 million a year and you can handle the
interest it would be 14 million bucks interest in year one but you would also
owe 20 million in principle pay downs at 34 million in year one and well frankly [Interest payments for year 1]
that's where you get nervous that's a lot of cash out of your pocket here...
If things don't go perfectly smoothly in your profit margins of the combined
company specific romeo' are less than you'd plan well then you could risk
putting the company in financial peril even bankruptcy because you know that if [Car driving by and stock value stamped with bankruptcy]
you don't pay back debt according to the deals terms, well then at least in theory
the debt holders could knock on your door one day and take ownership of your [Chains engulf Specific Motors]
company yeah company suicide, career suicide, the
financial end of the world as you know it so you look at paying the 200 mil in
equity instead of debt and you're wondering how to assess that cost got it
so you have a billion dollars you're going to give a fifth of that or 200
million dollars to the shareholders of Alfalfa Romeo in return for their excellent
cars all right well on your own this year you'll have three hundred million [Revenues for Specific Motors]
dollars in revenues to specific motors to deliver 40 million dollars in
earnings you trade at 25 times that 40 million of earnings billion dollars
remember you have 50 million shares outstanding trading at 20 bucks a share
do the math on both sides and you'll get a billion dollars either way see we do
it here for you at no extra charge at shmoop you can see it right there on the [Man points to Shmoop calculations]
screen....
well your business doesn't have a lot of research and development not big capital
expenditures so most if not all of your earnings is cash earnings that is of the
40 million dollars in earnings this year well close to a hundred percent of it is
cash we'll just call it that for this problem all right well if all you were
was a dividend producing machine well then this year you would be showing a [Machine producing dividends]
"free cash flow yield" of four percent or 40 million dollars in
cash generated by the billion-dollar market cap company that you have going
on there got it that's 40 million over the billion dollar valuation it's like a
4% cash yield for investors meaning if you paid $20 for a share of [20 dollars transfers to a share of stock]
stock you got about 80 cents in cash production from it so that's 80 cents
over 20 bucks the combo gets you a 4% cash yield so yeah that's how you assess
the cost of equity, you're paying for things in all stock with about 4% kind
of yield money so if you're paying a fifth of the company to buy Alfalfa
Romeo well you're gonna dilute that cash yield down and then you just have to do [Maths book opens]
the math whether Alfalfa Romeo generates enough cash to make the difference to
you does that make sense Otay! [Man waves]
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WACC is an acronym for weighted average cost of capital. A company can raise money either through selling equity or by raising debt. When measuring...