Friday, 27 November 2015

Capital Management in Personal Finance

A simple equation in finance describes your approach to capital management:

Assets = Debt + Equity

Everything you own was funded either by incurring debt or by expending your own resources.

Subtracting all your debt from the total value of your assets shows you how much equity (net wealth) you have accumulated.

The BALANCE of debt and equity you have used to fund the value of your assets is a critical portion of your financial management strategy, known as CAPITAL MANAGEMENT.

Cost of capital

Whether you use debt or equity to fund your asset ownership, there are COSTS OF DEBT and EQUITY involved, known collectively as COST OF CAPITAL.

The cost of debt refers to the amount of interest you will pay over the life of your debt.

Most people don't realise that there is also a cost associated with using your own resources to purchase assets, known as the "cost of equity".

"OPPORTUNITY COST" is the value of the next best option; so if you have the choice between purchasing furniture and keeping your money in a bank account, the opportunity cost of buying the furniture is equal to the amount of interest you would have earned by keeping your money in the account.

This makes most purchases far more expensive than people realise, since each purchase you make not only includes spending money, but also losing any earnings on that money if you hadn't spent it.

Effective capital management

Effective capital management requires you to assess the cheapest sources of both debt and equity being used to fund your assets, and also to find the proper balance of equity and debt so that you choose the cheaper of the two at any given point.

As you come to rely on one more than the other, its costs will start to increase; the more debt you have, the more lenders will start to charge you in interest rates as a result of the shift in your credit report.

If you rely more on equity, you will begin to pull assets which are more valuable, making debt cheaper compared to the money you would be losing by selling your investments.

The goal is to maintain the lowest cost of capital possible, using variations on the core equation:

Cost of capital 
= Cost of Equity + Cost of Debt
= [(E/A)*CE] + [(D/A)*CD]

E= The amount of equity you have
D= The amount of debt you have
A= The total value of your assets (D+E)
CE= The average cost of your equity (the money you would earn o the next best option)
CD= The average cost of your debt (the interest payments you will make)

E/A= weight of source of capital from equity
D/A= weight of source of capital from debt

You can assess whether your debt or equity is costing you more money from the above equation, to help you to determine the proper balance.

If these are not about equal, it is likely you could fund your assets more cheaply.

Are your assets generating returns more than the cost of capital?

Adding the cost of equity to the cost of debt gives you the total cost of capital.

The question remaining is whether your assets, on average, are generating MORE value than they are costing.

If yes, good for you.

If not, keep trying, because  right now you are losing money on your assets.

This equation only gives you a rough idea of your cost of capital, though.

The more precise you can be, even to the point of breaking down each source of debt and equity individually, the more accurate your calculation will be.

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