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The Price of Money: Determining the Cost of Capital
Published on Jun 27, 2012
Read 'The Price of Money: Determining the Cost of Capital' at 'Time to Start Up,' the small business blog by BizFilings.
Money doesn't grow on trees.
The familiar saying implies that money is not freely available. In fact, like other scarce resources, money has a price tag. The price you pay for money -- that is, capital -- to fund your business might not be simple to determine, because unlike a laptop or a piece of real estate, money does not come with a conventional price tag. However, you'll want to figure out the cost of capital, in order to decide what financing is worthwhile and will best help you grow your enterprise. Different kinds of capital -- such as personal savings, debt and equity financing -- are associated with different costs.
Many entrepreneurs use their personal savings as startup capital. It might not seem as if there's any cost associated with this capital -- you've earned and saved this money, and now you're using it to build your own business. But consider that you could spend your hard-earned money on any number of things, not just starting a company. This means there is an opportunity cost involved in using your funds for a startup.
Sometimes, it's easy to determine opportunity cost -- Investopedia gives the example of choosing to buy a stock over a bond. If the stock returns 2 percent annually and the bond yields 6 percent, your opportunity cost in choosing the stock instead of the bond is 4 percent. However, opportunity cost is not so straightforward when starting a business.
If your business is a great success, you will be happy you used your own savings to start it; however, if your business does not pan out, you may regret not using the funds in some other way, for example, by investing in a safe savings account, which would have all but guaranteed some growth. In other words, the cost of using your savings as business capital can't be determined with absolute certainty, but you should absolutely be aware that there is a cost, and think about whether the odds of business success are high enough to warrant using your own dollars.
The cost of debt capital is relatively easy to determine, although perhaps not as straightforward as it would seem, due to taxes. The basic cost of debt is the interest you're paying to borrow money from banks or other lending institutions or, if your company has issued bonds, bondholders. However, interest payments on debt financing are generally tax-deductible, so to figure the cost of debt capital, you need to take this into account.
There is a basic formula for determining the cost of debt:
Cost of Debt = Interest Rate(1 - Marginal Tax Rate)
This equation can be refined by taking into account things like a risk premium, which represents the probability of default.
Also consider that some banks or other lenders will ask you to personally guarantee a loan, which means you're pledging to pay back the loan even if your business cannot. A personal guarantee is unsecured -- meaning you are not putting up your personal assets as collateral on the loan -- but it does provide the lender with some ground for pursuing legal recourse against you to seize your personal assets if you can't repay the loan.
It's more complicated to calculate the cost of equity financing than debt. Some costs are not strictly monetary. By securing equity financing in the form of venture capital, you're allowing investors to buy into your company, which dilutes your ownership and control over the enterprise. While having savvy investors who can act as advisers can be a great benefit to your company, this has to be weighed against the loss of autonomy that comes with equity financing.
Although you're not making interest payments to investors, shareholders also expect a return on their money. Because shareholder payouts are dependent on market fluctuations, the equation for figuring the cost of equity is complex and subject to debate even by financial experts. The most widely known formula is the Nobel Prize-winning capital asset pricing model. The CAPM takes into account:
The risk-free rate of return (often the interest rate on U.S. Treasury bills)
The "beta," which is a measure of how much the company's securities will fluctuate in value compared to the market as a whole
The equity risk premium, or the return expected by investors, considering they are taking a risk in buying stock - this is calculated by subtracting the risk-free rate from the historical return of the stock market
While coming up with a specific figure for the cost of equity can be a complicated process, the general concept to remember is that the costs of equity capital are high relative to debt capital, because investors are taking a bigger risk than lenders in financing your company.
Once you've calculated the cost of debt and equity capital, you can figure out the weighted average cost of capital (WACC) for your business as a whole by considering your capital structure. A startup might be entirely funded with personal savings and debt, but some experts say a healthy structure for a mature company would be about 40 percent debt financing to 60 percent equity. In this scenario, the WACC is simply the cost of debt multiplied by 40 percent, added to the cost of equity multiplied by 60 percent.
Although this is a simplified example and in real-world scenarios you may have to consider subtleties like the difference between common and preferred stock, the WACC is essentially just the sum of equity and debt costs. The WACC can also be used to figure the cost of capital you want to raise for a particular project that will be financed through a mixture of debt and equity, allowing you to determine with greater certainty whether you can afford the expansion.