Product Managers Need To Know What Their Company’s Cost Of Capital Is

by drjim on May 20, 2013

To get your product funded, you're going to need to know your cost of capital

To get your product funded, you’re going to need to know your cost of capital

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You’ve just been put in charge of managing the best product ever. Based on the product development definition, you know that this product is going to be a run-away success: it solves a critical problem that a lot of customers are currently facing. There’s just one problem: either the product does not yet exist or it exists, but doesn’t do what it needs to do. You’re going to need some money – what’s it going to take to get your company to fund your product?

What Is The “Cost Of Capital”?

One of the things that too many product managers forget is that their company does not HAVE to fund their product. Yes, we can get all caught up in the fantastic market potential of our product, but from the company’s perspective there are a lot of other things that they can do with their money.

What this means is that when you go asking for the funding that you are going to need in order to make your product successful, you are going to have to convince some people that your product represents the best place for the company to spend its money. This means that you’re going to have to have a talk about the cost of capital. Figure this one out and you’ll have something else to add to your product manager resume.

Generally speaking, the company’s finance department is going to be in charge of running the numbers on your request for funding. What we product managers don’t often realize is that the company many not have the money that we’re requesting just sitting around. Instead, in order to fund our product, the company may need to dip into both its cash reserves (equity) as well as going out and borrowing some money.

Exactly how they go about doing this is something that too many product managers take a hands-off approach to. I’m going to suggest that we spend a little time talking about what you need to know about your cost of capital so that you’ve got the best chance of getting the funding that you want.

6 Assumptions Your Company Makes About Their Cost Of Capital

The world of finance can be mysterious to many product managers. However, with a little investigation you can quickly learn enough to be able to have a good discussion with your colleagues in the finance department. Here are 6 assumptions that your finance team may be making about how much the capital for your project is going to cost the company:

  1. Investment Time Horizon: We all know what this one is: how long after they give you the money is your product going to start to make money for the company? All too often a finance department has one set value that they use for this (1 year, 5 years, etc.). However, the investment time horizon should vary according to your product: innovative products will take longer to generate a profit than line extensions.

  2. How Much Does Debt Cost?: When the folks in finance are trying to determine how much it’s going to cost the company to borrow the money that they’ll spend on your product, they need to find a benchmark to use. All too often a finance department will use the current average rate on outstanding debt. This is the wrong way to do it. They really need to be using the forecasted rate on new debt issuance. Make sure that they’re doing it the right way!

  3. The Risk-Free Rate: When trying to determine how much of a return your product should generate, finance people generally start by trying to determine how much of a return an investor would want to get from a risk-free investment. What this means is that they take a look at how much the U.S. Treasury is paying on investments. However, this is where the problem can pop up: which U.S. Treasury rate will they be looking at: the 10-year rate, the 5-year rate, or the 30-year bond? Make sure that when your request for funding gets compared to other requests, that an apples-to-apples risk-free rate rates are being used.

  4. Equity Market Premium: Because investing in any project is risky, your finance department will be determining a risk premium for the funding that you are requesting. Many companies use a number between 5%-6%. However, this is probably an old number that hasn’t been changed in a long time. Take a look and see if you think that it should go down. If so, have a talk with your finance department.

  5. Beta: The volatility of your company’s stock plays a role in how much equity is going cost. A beta that is greater than 1 means that the company has greater-than-average volatility. A beta less than 1 means that your company has less-than-average volatility. Where a product manager may run into problems is when your finance department can’t agree on what time frame to measure the company’s volatility over: 1 year, 2 years, 3 years, or 5 years?

  6. Debt-To-Equity Ratio: It turns out that your product may be financed by a mixture of cash that the company has (equity) and debt. How much of each to use is something that the finance department needs to determine. The problem is that they often can’t decide if they should base this decision on the company’s current book debt, targeted book debt, or current market debt. Picking the wrong one can drive your cost of capital way up.

  7. Risk Of The Product: The final factor in determining the cost of capital for your product is to come up with an overall risk factor for your product. If the company takes a look at another product with a comparable level of risk, then they are doing it correctly. However, if they just tack on a percentage point to the value that they’ve already calculated for your cost of capital then they are doing it wrong. Find out how your finance team is coming up with this number!

What All Of This Means For You

The next time that you are handed a product to manage, you need to review your product manager job description and take a careful look at what you are being given. There are probably some changes that need to be made to your product in order for it to truly be successful. This means that you are going to need to get some company funding.

In order to get the funding that you need, you’re going to have to work with the company’s finance department. They’ll be using the company’s cost of capital to make funding decisions about your product. This means that you are going to have to use the 6 techniques that we’ve discussed to make sure that they are using the correct cost of capital.

The world of finance can appear to be strange and intimidating to an uneducated product manager. That’s why you need to learn about the cost of capital and then sit down and talk with your finance department in order to ensure that you’re going to get the best deal possible for your product. If you are going to be a successful product manager, then you’re going to have to know how to speak the language of finance.

– Dr. Jim Anderson
Blue Elephant Consulting –
Your Source For Real World Product Management Skills™

Question For You: If your finance department is using a cost of capital that you know is too high, what should your first step be to fix this problem?

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What We’ll Be Talking About Next Time

Based on the product development definition that you used to create your product, your product is the best available product to solve the problem that your customers are facing. This means that your customers should all be buying from you and your competition should just dry up and blow away, right? For some odd reason, that does not seem to be happening. Product managers who want their products to beat the competition need to do some homework in order to find out just exactly what their completion is up to…

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