Cost of Capital

In traditional corporate finance and academia, a company's "Cost of Capital" (often calculated as WACC - Weighted Average Cost of Capital) is used as a hurdle rate. A company is told to only pursue projects or acquisitions that yield a return higher than this calculated WACC.

Warren Buffett and Charlie Munger explicitly reject this academic framework for Berkshire Hathaway.

💡 The Berkshire Definition: Opportunity Cost

At Berkshire Hathaway, the cost of capital is not derived from beta, risk-free rates, or complex theoretical formulas. Instead, the cost of capital is exclusively defined by Opportunity Cost.

"We don’t care about the cost of capital. We care about opportunity cost... I mean, if we’re making 15 cents on something and somebody comes along with something that makes 15 and a half cents, we take the 15 and a half cents." — Warren Buffett, 2014 Meeting

The absolute required return for a project is simply whatever the next best available use of that capital would yield. If Berkshire has $10 billion in cash, and the best available index fund or bond yields 4%, then a new acquisition must exceed 4%. If another acquisition is available yielding 10%, then the cost of capital for any other project becomes 10%.

📉 Rejection of WACC

Munger specifically ridicules WACC and the idea that a company has a fixed, calculable "cost of equity."

1. False Precision: The formulas rely on historical price volatility (Beta) to determine the cost of equity, which Berkshire views as a flawed metric for risk (see Volatility vs Risk).
2. Ignoring Reality: When cash is yielding 0% in Treasury bills (as it did following the 2008 crisis), stating a company's generic "cost of capital is 10%" might prevent management from making mildly accretive investments that are vastly superior to holding cash.

🔗 Connections

• Concept: Opportunity Cost
• Concept: Capital Allocation
• Context: 2014 Meeting

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