Monday, April 4, 2011

Cost of Money Versus The Value of Money

Cost of money is what it cost the company to borrow they money. A company’s cost of money will be dependent upon the prevailing interest rates at the time and will be impacted by the company’s financial position. The weaker the financial position of the company, the more risk to the lender, so the higher the rate of interest that would be charged. 

The Value of Money is the rate of return a company could make on an investment.  Most Companies will also have what they call a “hurdle rate”. A Hurdle Rate is nothing more than the minimal rate of return they want to make on an investment before they make that investment. Hurdle rates take into account the fact that companies have limited money available for investments and may have limits on what they can borrow. So one way of prioritizing amongst the investments is whether an individual investment meets their hurdle rate. Hurdle rates are always higher than the cost of money as you would need to cover either the cost or value of the money that’s used to make the investment and you need to provide a return on that investment. 

Between the Buyer and Supplier there may frequently be differences between what those rates are. For example a very large buyer with great financials may have a substantially lower cost or value of money than a small Supplier with weaker financials. There may also be substantial differences in hurdle rates to make investments. Companies that have major spending needs for acquisitions, research and new product developments with new technologies frequently have high hurdle rates whereas companies in very stable industries will have traditionally lower rates.

What does all of this have to do with negotiations? The differences in rates can present opportunities in the negotiation. The simplest example of this is Suppliers with a high cost of money may be willing to offer discounts for shorter payment payments. The differences in rates can also help decide which company should be the banker in the relationship. For example, if a company offers to amortize some or all of the development cost in to the cost of a product or service, there’s usually a cost to do that.
The cost they propose will be based upon their value of money or hurdle rate. Your decision on whether to accept it will depend upon your value of money or hurdle rate. Large companies may have their Treasury department provide periodic advise on when to accept early payment discounts based upon changes to their value of money and hurdle rate. The same thing would apply to all other investment decisions in the relationship. For example who should hold Inventory. Ideally if inventory needs to be held the party with the lower value of money and lower hurdle rate should hold it. If you try to have a Supplier that has a high value of money and high hurdle rate into doing stocking for you, what you are really doing is asking them to make an investment in holding that inventory. If you have substantial leverage you may be able to force them to do it, but you can expect that the price you pay will include their cost at their value of money or their hurdle rate to do it.  What you pay may also be more than if you made the investment.

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