The Cost of Capital
- Yoel Frischoff
- Jul 8
- 6 min read
Updated: Jul 14
Time Value and Risk Premium
Business Models for Smart Products - Chapter 2
Scope:
In the previous chapter, we explored costs, volumes, and contribution margin. However, two critical dimensions were left unexamined:
Time, and Risk.
These factors are fundamental in shaping a project’s true profit potential, as they define the opportunity cost of capital - the value of the best alternative foregone when choosing one investment path over another of similar risk.
A clear understanding of both internal and external factors enables management to make fair comparisons—oranges to oranges. A project must first meet its own internal profitability threshold. Only then can it be meaningfully evaluated against other available opportunities that carry comparable risk.
What Is the Time Value of Money?
The cost of capital is partly determined by the time during which money is committed.
If you borrow money today, the lender expects compensation not just for the amount itself, but for the fact that it is unavailable to them during the loan period.
One reason or justification is simple: A Dollar today is worth more than a Dollar a year from now. Inflation alone accounts for that, as the cost of living increases over time: the purchase power of that coin erodes over time.
This compensation is expressed through interest.
There are two primary ways to calculate interest: simple and compound.
Simple Interest
In this model, interest is calculated linearly based on the original amount (the principal).
Bₙ = B₀ + n × R × B₀
Where:
Bₙ: Total repayment at the end of period n
B₀: Initial borrowed capital
n: Number of periods
R: Interest rate per period
Example: Borrowing $100 at 7% interest for 5 years → Bₙ = 100 + 5 x (1.07)⁵ ≈ $135
Compound Interest
Here, interest is calculated on both the principal and the accumulated interest from previous periods.
Unlike simple interest, compound interest grows exponentially over time.
Bₙ = B₀ × (1 + R)ⁿ
Where:
Bₙ: Total repayment at the end of period n
B₀: Initial borrowed capital
n: Number of periods
R: Interest rate per period
Example: Borrowing $100 at 7% compound interest for 5 years: ➔ Bₙ = 100 × (1.07)⁵ ≈ 140.3
This is nearly 4% more than the simple interest scenario.Over longer periods, the gap becomes dramatic - after 20 years, for instance, compound repayment is over 60% higher.
As Albert Einstein most probably did not say:
Compound interest is the most powerful force in the universe.
Product Implications - Focus on features that accelerate revenue generation
Features or products that generate revenue (or learning) sooner are more valuable than those that take years to pay off.
MobileAccess Example:
This is a pure hardware example. Mobile Access (Then Foxcom, later acquired by Corning) came with ModuLite, a series of multi carrier multiplexers channeling RF signals over fiber optics from external antennas to in-campus base stations.
From the outset, this series was planned to be mass produced. The enclosure material being Aluminum to help dissipate residual heat was supposed to be die cast - a process that would result in low cost, high quality moldings. The problem: Injection dies manufacturing is a lengthy process, with duration of 3 – 6 months for similar products, only then you have to ship the dies to a local facility, or - alternatively - inject overseas and ship the empty enclosures for assembly and testing: Account for additional weeks in transport, customs clearance.
This project, however, was not born in vacuum: A pressing order was due, critically important to the financial prospects of the company.
The solution found for this dilemma was to manufacture the first batch of several hundred units using machining - a much slower, much expensive, and in the long run unsuitable for mass production.
The decision lenses were:
How fast can you get to the market?
How fast can you start charging for your product?
How much would you lower your margins to expediate revenue?
True, in software the answer is usually clearer, with marginal costs approaching 0...
Risk and Risk Premium
The time value of money, with the relatively constand fact of inflation, does not, however, comprise the whole picture when it comes to the cost of capital.
Enter Risk.
While time is an absolute, Risk is a little more subjective, and it is assessed by the lender (or investor) -based on rating agencies, industry analysts, and the investor's own assessment, based on their domain knowledge and experience. No way to avoid uncertainty: Will the borrower repay on time? Will the return on investment be positive?
To compensate for this , well diversified* lenders apply a risk premium on top of the baseline ("risk-free") rate. * A well-diversified investor spreads investments across a variety of asset classes, sectors, and geographies to reduce exposure to individual risks and achieve more stable long-term returns.
iT = Rf + Rp
Where:
iT: Total interest rate
Rf: Risk-free rate (e.g., government bonds)
Rp: Risk premium (reflecting borrower/investment risk)
Example: If government 10-year bonds (until recently considered 'risk-free') yield 0.9% interest, and a venture is considered high-risk, the investor might require a total return of 12%-20% from the venture.
Let's discuss this example a bit more.
Suppose you are a lender extending credit to 100 borrowers, of which 5% will default. Let's also assume for simplicity risk premium is the only interest you charge.
If you lent $1 each, and 5% default, you are bound to be $5 in the hole, at the of the cycle.
In order for you just to recoup your initial capital of $100, you must require ~5.3% interest.
This would be the Risk Premium.
The problem is, of course, you cannot know in advance the amount of defaults in any single cohort – all you have are assessment and actuary calculations, depending on the nature of the loan (or investment), the time frame, the heterogeneity of borrowers, and the overall economy.
Product Implications - Choose MVPs that de-risk future investments
The more uncertain a project’s outcome, the higher the expected return must be to justify pursuing it. PMs must frame early efforts as risk-reduction activities. After all, isn't the whole 'Lean' movement just about that?
tvDots MVP:
TVDots slogan was:
Your Newspaper. Now on TV.
Ambitious as it was in pre-LLM 2020, the startup combined text-to-speech and video-creation technologies to convert any news site into an automated, live, TV broadcast grade channel stream.
The technical challenges were substantial. How can you automatically ingest and parse news stories into a narrator ready text? How do you avoid silly errors and monotonous mechanical narration? Can you do it at scale?
Instead of building the full pipeline, AudioDots opted for integrating 3rd party services both for the TTS and video generation, at a cost of limited control, and substantial uni cost: Each newsclip incurred significant production costs, that would have been minimized with homebrew technology stack.
The decision lenses were:
What’s the smallest version of this initiative that reduces uncertainty and still yields usable data?
How fast can you get in front of paying customers and design partners?
Opportunity Cost of Capital
At the core of every investment decision lies a fundamental question:
“Do I have better use to this capital?”
Investing a significant amount in a new product doesn’t just commit funds - it closes the door, at least temporarily, on other potential opportunities. Those alternatives might be more profitable, carry less risk, or deliver returns faster.
This trade-off is what defines the opportunity cost of capital. It's not just a financial calculation - it's a reflection of strategic priorities, resource constraints, and competing bets on the future.
In product development, where risk is high and resources are limited, understanding this cost is essential. It helps ensure that capital is not just used wisely, but used where it creates the most value.
Product Implications - Ruthless prioritization
Given the competitive nature of all industries, let alone startups racing for supremacy necessary for survival, the cost of capital question boils to prioritization.
What should we build now, what will have to wait?
Prioritization is worth a chapter in its own, especially when addressing smart tangibles (which weigh differently: Hardware gambles are riskier and longer). However, I find RICE the most relevant to the issue of opportunity cost of capital.
RICE – Reach, Impact, Confidence, Effort – helps prioritize features by estimating their potential value vs. the effort required.
Considered great for growth and roadmap decisions, it allows comparison between competing strategic alternatives, through the lens of financial planning.
Read about Net Present Value in Part 3: Net Present Value - Measuring Profitability
Back to the directory: Smart Business Models for Smart Tangibles
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