Return on capital | Finance & Capital Markets | Khan Academy

Welcome to the introduction about return on capital We say return on capital Now I want to talk about this concept first Because i think it will give you a big frame Tell you how to think about the value of something Should you invest your money in it How should you weigh Different investment options You want to deposit it in the bank You want to use it to buy a house You want to pay off your credit card and so on So let’s define “return on investment” you know I may not strictly follow In terms of accounting concepts I have to do more hands-on practice How should “Joe Investors” use their money So here I define the “return on investment” as The cash you get every year Divide by the total cash you put in It doesn’t have to be cash There are other ways to measure yield But let’s say it briefly We only talk about cash We consider how this is calculated I have an idea i have a restaurant That restaurant will cost $1 million Investment amount Per year After paying all fees After paying all public facility fees After paying all employees After repair and maintenance after tax This restaurant makes $100,000 a year In this case follow the way I defined it My return on capital Is 100,000 divided by 1 million Equal to 10% Pretty straightforward You might say Thrall.

It’s so easy. Why are you wasting my time? Ok it might be so But I think you will find this is Lay the foundation for difficult knowledge points later We go on Okay restaurant’s return on capital Equal to 10% I invest 1 million dollars every year I will make 100,000 dollars This is the project We say i want- I haven’t considered the risk yet I know exactly if I invest my money here I will get 10% of the money I invested We said another option for my money is Invest in beauty salons That would cost 1 million dollars This beauty salon brings me $50,000 in income every year I think which project you are more willing to invest in Is very obvious Because the investment yield of beauty salons It’s just 50,000 divided by 1 million or 5% So obviously You want to invest in restaurants instead of beauty salons Generally speaking After considering the risks You always want to invest in Projects with higher return on capital Later based on when you get the reward There will be nuances If you get money faster Maybe the rate of return is a little lower and you will be willing Or if you take the risk or compensate for the risk You want a slightly higher rate of return So we know we want to invest in restaurants But do we have to invest in restaurants? I mean we want to invest in restaurants more than beauty salons My question for you is Do we have to invest in restaurants? This is where the return on capital becomes interesting Because before we invested our money in the restaurant These considerations are important to us Consider the cost of this money I think this will A new concept is slightly involved I now introduce to you The concept “cost of capital” This restaurant costs $1 million Brings me a return of $100,000 per year.

This is a 10% return on capital Suppose i have to borrow all this money Some banks are willing to lend me this money Invest in this restaurant Interest rate on these borrowings Is 15% Is opening a restaurant still a good idea for me? Ok if i have to take full loan I took a loan of 1 million dollars Bought this restaurant I will be charged 15% interest every year I am not going to consider taxes And the loan can be partially tax deductible, etc. Don’t consider these for now we assume that My total cost per year is 15% interest So I have to repay $150,000 in interest every year So my question is Does opening this restaurant still make sense to me? Every year I will start from the restaurant itself Earned $100,000 But I will pay $150,000 in interest every year You might say Thrall, this is still obvious You won’t want to invest in this restaurant Because every year you lose 50,000 dollars Now you might think this is very obvious But now I will show you many People’s practical examples They will do this calculation This will especially appear in the housing market But anyway in this case You don’t want to invest in it A very simple way to think about this kind of thing Is you just in this situation Want to invest or want to do a project If your return on capital Higher than your cost of capital This is the only situation where you want to invest in a project I just showed some things that we thought were obvious But I want to ask you one more question We have a restaurant We have a beauty salon They both cost $1 million The restaurant’s ROC (return on capital) is 10% The return on capital of the beauty salon is 5% right now It looks like the restaurant is a better project But then we talked about the cost of capital These interest This is a measure of how much we spent to get $1 million Interest rate is 15% We say it’s not a good investment Because our cost of capital Greater than capital return But what if there is some form of government support They feel There are too few beauty salons in this country They want to give you a cheap loan Go to buy a beauty salon The government plan says We intend to give you a low interest loan of 2% So my question for you is Which project are you more willing to do now? On the surface, the restaurant looks better You get a 10% return instead of 5% But the cost of capital Interest on loan repayment for beauty salon Suddenly looks a little better In fact, this is actually a good investment Because of your cost of capital Lower than your return on capital We can calculate Every year beauty salon will earn 50,000 And you will pay 20,000 interest So you will make a net profit of 30,000 You don’t need to pay All money is loaned very clearly This is a good investment In this lesson we introduced Return on capital and cost of capital In the next lesson I will introduce 170 00:09:46,080 –> 00:00:00,000 in more detail and give some different examples

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