The cost-of-capital concept is a cornerstone of corporate finance. Here we take a different view: What is the cost to society for managing its capital? We look at the U.S. and find that the cost is surprisingly high compared to the capital return: around 25 cents for each dollar returned. The analysis explains parts of the financial crisis and the pressure on the financial sector since.
This analysis combines national accounts data from the U.S. Bureau of Economic Analysis and Thomas Picketty’s underlying analyses for Wealth in the Twenty-First Century.*
Capital Base in the U.S.
Estimating total capital in the U.S. is difficult. Fortunately, Piketty provides a time series which expresses total capital (net worth) as a share of national income. His estimate takes into account private and public capital (assets and liabilities) and divides it into financial, housing, and land capital, as well as net foreign capital. He further takes into account the need for replacement of depreciated assets. His finding is that U.S. net worth presently is a bit over 400% of national income and that it has grown 4.3% per year in current values.
Return on Capital
Piketty further provides the return on capital expressed as a share of national income. Converting this into return on capital (using the 400% ratio above), we find that the average return is 6.0% over the 17 year period. Again, this includes all asset and liability classes.
Cost of Capital
The administrative cost of managing this capital is a complicated calculation. We turn to BEA’s detailed tables of the components of GDP.
First, we include parts of the “Finance, Insurance, Real Estate, Rental, and Leasing Sector”. For Finance and Insurance, half of insurance is deducted because it relates to non-capital insurance (e.g., health insurance). For Real Estate, 16% is included as capital-related, while 84% relates to costs such as landscaping and groundskeeping.
Second, the national accounts include both labor and capital. We are only interested in the labor component (to avoid double counting). Fortunately, BEA’s detailed tables contain this split.
Third, the sector buys intermediate products and services from the outside. The labor cost component of this also needs to be included. Again, the BEA tables are detailed enough to allow for this calculation.
This administrative cost of capital peaked in 2007 when the financial crisis started. It’s probably not a coincidence.
The cost of managing the capital base is high compared to the returns generated. Since 1997, the cost has averaged 31 cents for each dollar of return generated. Between 2000 and 2008 the average was 34 cents, suggesting large inefficiencies in the financial system. Since 2008, the cost has declined 36% and today’s cost of capital is the lowest in the entire period studied. However, there may be room for further decline as information technology cuts cost.
A reason for the high cost of managing capital is probably the complexity of financial products, and the difficulty to underwrite correctly.
Finally, we revert to the classic formula for cost of capital in corporate finance. While it exists for a different purpose than the analysis above, one may wonder where the administrative cost of capital hides.
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* The underlying spreadsheet is available here