Here's an interesting exchange from back in 1996 between Professor William Bratton of the Rutgers-Newark School of Law and Charlie Munger.
Bratton: I think we all know what an optimal investment is.
Munger: No, I do not. At least not as these people use the term.
Bratton: I don't know it when I see it...but in theory, if I knew it when I saw it this conference would be about me and not about Warren Buffett. (Laughter from the audience)
Munger: What is the break point where a business becomes sub-optimal or when an investment becomes sub-optimal?
Bratton: When the return on the investment is lower than the cost of capital.
Munger: And what is the cost of capital?
Bratton: Well, that's a nice one and I would…
Munger: Well, it's only fair, if you're going to use the cost of capital, to say what it is.
Bratton: I would be interested in knowing, we’re talking theoretically.
Munger: No, I want to know what the cost of capital is in the model.
Bratton: In the model? It will just be stated.
Munger: Where? Out of the forehead of Job or something?
Bratton: That is correct. (Laughter)
Munger: Well, some of us don't find this too satisfactory. (Laughter)
Bratton: I said, you'd be a fool to use it as a template for real world investment decision making. We're only trying to use a particular perspective on human behavior to try to explain things.
Munger: But if you explain things in terms of unexplainable sub-concepts, what kind of an explanation is that? (Laughter)
Bratton: It's a social science explanation. You take for what it's worth.
Munger: Do you consider it understandable for some people to regard this as gibberish. (Laughter)
Bratton: Perfectly understandable, although I do my best to teach it. (Laughter)
Munger: Why? Why do you do this? (Laughter)
Bratton: It's in my job description. (Laughter)
Munger: Because other people are teaching it, is what you're telling me. (Laughter)
Buffett and Munger both expressed, rather bluntly, their skepticism toward the idea of cost of capital during the 2003 Berkshire Hathaway (BRKa) shareholder meeting.*
Notes from the 2003 Berkshire Hathaway Annual Meeting
Buffett: Charlie and I don't know our cost of capital. It's taught a[t] business schools, but we're skeptical. We just look to do the most intelligent thing we can with the capital that we have. We measure everything against our alternatives. I've never seen a cost of capital calculation that made sense to me.
Charlie Munger then chimed in with this:
Munger: The rest of the world has gone off on some kick -- there's even a cost of equity capital. A perfectly amazing mental malfunction.
Munger is complimentary about other aspects of Professor Bratton's work and he made that clear after the exchange above occurred. He just has a problem with the way that cost of capital is often taught and, in his own unique way, certainly made that point very clear during the exchange.
* The comments of Buffett and Munger are based upon the notes taken by Whitney Tilson
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