Chapter 7
Types and Costs of Financial Capital
Implicit and Explicit Financial cost
Explicit costs are normal business costs that appear in the general ledger and directly affect a
company's profitability. Explicit costs have clearly defined dollar amounts, which flow through to
the income statement. Examples of explicit costs include wages, lease payments, utilities, raw
materials, and other direct costs.
Implicit cost is any cost that has already occurred but not necessarily shown or reported as a separate
expense. It represents an opportunity cost that arises when a company uses internal resources
toward a project without any explicit compensation for the utilization of resources.
Examples of implicit costs include the loss of interest income on funds and the depreciation of
machinery for a capital project.
While accountants recognize that financial capital has a cost and recommend its complete inclusion in
performance appraisal and decision making, historical accounting for this cost is incomplete, at
least in formal financial statements.
Unlike debt, much of equity’s cost is not an expense in a traditional accounting sense (with
documentation); only a part of this cost (e.g., dividends) is reflected in historical financial
statements. There is virtually no historical accounting for the nondividend component of equity’s
cost, even though it is clear that the nondividend cost component increases with cuts in dividends.
The Value Of A Financial Claim Varies Inversely With The Cost Of That Type Of Capital.
For example, a bond’s price is related to its promised payments by an interest rate (yield) representing
the rental rate for using that type of capital.
Types of interest-bearing debt and equity financing,
financing sources and business riskiness by life cycle stage
Types of interest-bearing debt and equity financing,
financing sources and business riskiness by life cycle stage
In Development-stage venture’s business plan needs to make the case for potentially
achieving very high returns. In Figure, we depict development-stage ventures as having
very high business risk.
Startup-stage ventures also have very high business risk and are considered to be only
slightly less risky than they were in the development stage.
Survival-stage firms continue to have high business risk, and, accordingly, their investors
continue to seek high annual rates of return.
Rapid-growth firms are perceived as remaining highly risky during the early part of this
stage, although their business risk decreases to moderate levels as they successfully
emerge from rapid growth. Ex: Target annual rates of return exceeding 20 percent are
common for ventures in the rapid-growth stage.
In Early Stage Ventures, corporate finance focuses on more mature firms (typically,
corporations) operating late in their rapid-growth or maturity stages. Early-stage
ventures usually have access only to private capital markets. Mature corporations have
access to private and public capital markets. Ultimately, however, the private, public, and
even government security markets compete with each other for much of the capital
available for investment. Depending on the risk and returns offered, investors move
their investing attention from category to category.
Financial Market
Public financial markets
These are those involving the issuance, buying, and trading of standardized liquid
securities such as stocks, bonds, and options.
Successful, well-established corporations are the most common issuers of these public
market securities, although the Internet Age has changed maturity expectations
for some issuers. An initial public offering (IPO) of common stock, usually
accomplished with the aid of investment bankers, can provide liquidity stage
financing as a successful corporate venture moves deep into its rapid-growth
stage.
Public financial markets and financial institutions become the most common sources
of financing during a successful venture’s maturity stage. Financial institutions
become more willing to lend to the venture for several years at a time. Investment
bankers are available to assist maturity-stage corporations in raising financial
capital by selling the firm’s stocks and bonds to the public, to institutional
investors, and even to other operating companies.
Financial Market
Private financial markets
It involves the issue and sale of illiquid, less standardized financial contracts and
securities. Bank loans and privately placed debt (sold to financial institutions and
venture lenders) are examples of debt transactions in the private financial
markets. Although there are exceptions, bank loans become a likely funding source
only after a few successful years of operations.
Early-stage ventures in the development, startup, survival, or (early) rapid-
growth stages usually cannot tap into public financial markets.
For equity financing, early-stage ventures typically rely on private equity financing
from the entrepreneur and her friends or family, from business angels, and from
professional venture capitalists. Only in later stages does tapping the public equity
(stock) markets become feasible. By then, it may even be essential.
Cost of Debt Capital
One bears the cost of debt by making periodic payments equal to an interest rate multiplied
by the amount borrowed and by repaying the amount borrowed. In this arrangement,
the interest rate determines the cost of debt capital. In debt markets, the supply and
demand for funds determines the interest rate new borrowers must agree to pay.
In figure graphically illustrates the market determination of interest rates. In Panel A,
equilibrium (Q1) in borrowed and loaned funds occurs when supply (S1) intersects
demand (D1). The result is an interest rate we will call “r,” depicted as 8 percent. Panel
A also shows the interest rate for higher demand (D2) due to factors like overall
economic expansion. Notice that the quantity of funds borrowed and loaned increases
to Q2 as the interest rate rises to 10 percent.
Cost of Debt Capital
In addition to understanding that supply and demand interact to set interest rates, it is
important to realize that riskier debt costs more. The risk that a borrower may not
make an interest or principal payment is default risk. Lenders expect to be
compensated for such risk. Panel B in Figure depicts two possible supply/demand
relationships, one for low-default-risk debt and one for high-default-risk debt.
Note that the equilibrium interest rate for high-default-risk debt is higher than that for
low-default-risk debt. We have depicted the quantity demanded and supplied for
low-risk debt as being greater than that for high-risk debt. This represents the
normal case. The distance between the two interest rates depends on the relative
demand for the two types of debt and lenders’ willingness to lend at various interest
rate differentials between the two types of debt.
How interest rate fluctuates with the state of economy?
when the economy is growing, the willingness to lend (supply) to higher-
risk borrowers usually increases.
In the Boom-time period lenders may accept a smaller risk premium (an
interest rate closer to low-risk rates) when lending to high-risk borrowers.
During a recession period, lenders may be more conservative and demand
high-risk premiums. Consequently, recession-time lenders may demand
very high interest rates from high-risk borrowers or not lend to them at all.
Market Interest Rates
An observed or stated interest rate, such as the rate on a bank loan, is referred to as the nominal
interest rate.
It is common practice to state interest rates on an annual or annualized basis.
For example, the interest rates depicted in Figure are annual nominal interest rates. Recall that
Panel B displays possible interest rates for low and high default risk. In addition to default
risk, other factors—inflation expectations, marketability, and the life span of the debt
instrument—play important roles in determining the supply and demand of funds and
therefore, equilibrium interest rates.
The real interest rate (RR) is an abstract notion of the interest rate one would face in the absence
of inflation, risk, illiquidity, and any other factors determining the applicable interest rate.
Borrowers must pay more than the real rate (RR) to compensate the lender (supplier of debt
funds) for an inflation premium (IP), a default risk premium (DRP), a marketability or liquidity
premium (LP), and a maturity premium (MP). We can express these relationships in equation
form as follows:
r debt (or rd) = RR + IP + DRP + LP + MP
Risk-Free Interest Rate
The observed interest rate on such debt securities is called the risk-free interest rate, which we
will denote as rf. Most investors consider govt securities to have almost no default risk and
value them using risk-free rates.
Inflation occurs when rising prices are not offset by increases in the quality of the goods or
services being purchased. The result is a lower purchasing power for the same amount of
money. During inflationary times, to offset erosion in money’s purchasing power, even risk-
free securities are priced using higher interest rates. The result is an IP that is added to the
RR. The resulting nominal risk-free rate is:
Risk-Free Rate (or rf) = RR + IP
where the inflation premium (IP) reflects the expected inflation that will occur during the risk-
free loan.
Ex: consider a lender whose time value of money (RR) is 3 percent per year. If we believe that hot
tub (and general) price levels will rise 3 percent during the year of the loan, then to assure a
3 percent higher consumption from spending the funds next year, the nominal rate on the
loan will need to be approximately 6 percent. Using equation we have:
rf = 3% + 3% = 6%
Default Risk Premium
The default risk premium (DRP) is the additional interest rate premium required to compensate
the lender for the probability that a borrower will not pay the promised interest and principal
payments. The higher the quality of the loan or debt security, the lower the DRP and,
therefore, the lower the nominal interest rate.
Suppose the current risk-free rate is 6 percent, and a mature venture expects a 2 percent DRP.
Assuming no LP or MP, we would have the following inputs to equation:
rd = 6% + 2% + 0% + 0% = 8%
Banks have their own terminology for borrowers. Banks do not generally lend to the government
and, thus, make only risky loans. For their highest-quality (lowest default risk) business
customers, banks typically charge a prime rate. This prime rate establishes a benchmark rate
for loans to riskier customers.
For example, a moderately risky customer might get a “prime plus 2 percent” loan. If the prime
rate is 7 percent, this translates to a 9 percent borrowing rate (i.e., 7 percent + 2 percent).
Early-stage ventures, when they can get bank loans, might pay “prime plus 5 percent,” or 12
percent when the prime rate is 7 percent. Even the prime rate, however, is not as low as the
government’s risk-free rate.
Liquidity and Maturity Risk Premiums
In addition to inflation and default expectations, liquidity and maturity horizon may influence the
nominal interest rate on a venture’s debt. A liquidity premium (LP) is charged when a loan
or other debt instrument cannot be sold quickly at its existing value. Investment-grade debt
and prime loans usually can sell quickly at little, if any, discount to their true values.
In contrast, higher-risk loans and junk bonds may require significant lead time and/or discount
from true value to be sold quickly. Although we usually think of default risk and LPs as moving
together, one can observe different LPs for financial securities with similar default risk and
maturity.
A maturity premium (MP) is an added interest rate charge for long-horizon debt contracts.
Many think of this as compensation for additional interest rate risk in the long term.
For example, while the inflation realized over the next year will probably be close to its expected
level of, perhaps, 3 percent, it becomes increasingly risky to extend a fixed-rate loan (of, say,
7 percent) for ten or even twenty years when inflation could vary widely from current
expectations.
Term structure of interest rates
The relationship between nominal interest rates and time to maturity, when default risk is held
constant, is referred to as the term structure of interest rates. A yield curve is a graph of the term
structure of interest rate:
Yield curve is a graph of the term structure of interest rates.
Figure shows a typical upward sloping yield curve for Treasury securities. Assume that the risk free rate is
6 percent, based on a 3 percent inflation expectation and a 3 percent RR. An entrepreneur is
expecting to pay a five-percentage-point cost for default risk to obtain borrowed funds for five years.
The loan will be difficult to resell, and market norms dictate a three-percentage-point LP. Finally,
given the prevailing shape of the yield curve, the MP will average two percentage points over the life
of the five-year loan. The venture’s cost for this debt capital is:
rd = 6% + 5% + 3% + 2% = 16%
Senior Debt and Subordinated debt
Debt issues may be secured or unsecured.
Debt issue is secured by pledging a venture’s specific assets (plant, equipment, and/or working
capital) to be used in the event of default in satisfaction of at least a portion of the debt. Debt
secured by a venture’s assets is typically called senior debt.
Unsecured debt is typically referred to as subordinated debt, due to the inferiority of its claim
relative to the senior debt’s specific claim on venture assets. Subordinated debt has more
severe concerns upon default and, consequently, carries a higher interest rate.
Investment Risk
The word “risk” comes from the early Italian word risicare and means “to dare.”
It refers to risk as being a peril or hazard that results in exposure to loss or injury.
For example, the decision to ride a bicycle in automobile traffic involves the chance (risk) of
suffering bodily injury. Likewise, the decision to start a business, or to invest in someone
else’s venture, involves the possibility (risk) of financial or monetary loss.
Investment risk of loss is the chance or probability of financial loss on one’s venture
investment. Debt, equity, and founding investors all assume investment risk of loss.
Rate of Return on Investment
Returns on investment include any interest or dividends received, plus any change in the
value of the investment (appreciation or depreciation) over the period of the investment.
For example, assume that you are contemplating making a $100 investment in the HiTec
Company. You expect that at the end of one year you will receive $10 in cash flow in the
form of dividends and expect the investment’s value to be $110. Thus, the return would
be $20 ($10 in cash dividends and $10 in capital appreciation) on the initial $100
investment. Typically, this would be couched as an expected return of 20 percent. In
equation form, we have:
Thus, the rate of return is expected to be 20 percent.
Rate of Return on Investment
Now assume that the 20 percent return is expected for the HiTec Company only if normal
economic conditions prevail next year. The economy, however, could be either in a recession
or growing rapidly.
If a recession occurs, no cash dividend is expected from the investment and the investment’s
value is expected to fall to $80.
On the other hand, if the economy grows rapidly, the dividend is expected to be $20 with the
investment’s value expected to rise to $140. The returns expected under each scenario for
HiTec would be:
Expected rate of return
An expected rate of return is a probability-weighted average of all possible rates of return. Given only
these three possible rates of return, and assuming that the high and low returns occur 30 percent
of the time and that the normal return occurs the remaining 40 percent of the time, the expected
rate of return for the HiTec Company investment is:
However, that the realized return for the Hitec company maybe as low as −20 percent or as high as 60
percent.
Measuring Risk as Dispersion around an Average
The deviation, or dispersion, of outcomes around the expected return of 20 percent, typically
quantified by the standard deviation, is a commonly used measure of an investment’s risk.
The tighter the dispersion, the smaller the standard deviation and the lower the investment risk.
It is common practice to use the symbol σ, pronounced “sigma,” to indicate the standard
deviation. The standard deviation for HiTec is:
Panel A in Figure depicts an example of such a distribution for the HiTec Company. Panel A also displays
the expected return and the dispersion of returns for the BioTec Company. Notice that while BioTec
has the same expected return as HiTec (20 percent), it has a much tighter distribution around its
expected value. This is graphical representation of BioTec’s smaller standard deviation and lower
investment risk. Given investor risk aversion, when considering two otherwise identical
investments, investors will prefer the investment with a smaller dispersion of outcomes (lower
standard deviation).
In actual practice, investor choices are more complex than depicted in Panel A of Figure where two
investments had the same expected returns but different standard deviations. Most of the time,
investors face trade-offs involving higher expected return for assuming greater risk (standard
deviation).
Panel B of Figure shows the continuous probability distributions of possible returns for the LoTec
and HiTec Companies. The expected rate of return for LoTec is 10 percent. However, the
dispersion of possible outcomes is much tighter for LoTec, an investment having significantly
less investment risk.
Which opportunity would investors choose?
The answer is not obvious. It depends on the risk tolerance or risk aversion of each investor. We
can standardize the relationship between the expected rate of return and the standard
deviation. One way to standardize is by considering the ratio of standard deviation to
expected return, a ratio known as the coefficient of variation:
Coefficient of Variation = Standard Deviation/Expected Return
Assume that even after we have added more outcomes for HiTec, the standard deviation of
returns remains at 31 percent. Assume that the standard deviation for LoTec is 12 percent.
Using equation we have:
LoTec : Coefficient of Variation = 12%/10% = 1.20
HiTec : Coefficient of Variation = 31%/20% = 1.55
We see that the LoTec Company offers a lower dispersion per unit of expected return. Does this
mean that all investors would rationally choose LoTec over HiTec?
Answer is No! Highly risk-averse investors would almost certainly choose the LoTec investment
over the HiTec investment.
In contrast, investors with a higher tolerance for risk might choose to invest in HiTec because of
its expected 20 percent return. Of course, they will assume more risk (dispersion) in the
possible outcomes. The potential for higher return is sufficient to entice these investors into
taking greater risks.
Equity investors, like debt investors, expect to be compensated for the risk of the investment. Equity
investors may be private equity investors or publicly traded stock investors.
Private equity investors are owners of proprietorships, partners in partnerships, and owners in
closely held corporations, who would include entrepreneurs, business angels, venture capitalists,
and other private equity investors.
Closely held corporations are corporations whose stock is not publicly traded.
Publicly traded stock investors, as the name implies, are equity investors in firms whose stocks
trade in public secondary markets— either in the over-the-counter market or on organized
securities exchanges.
Equity capital is considered to be private until a venture’s stock is traded in public markets.
An organized securities exchange typically has a specific location with a trading floor where trades
take place under rules set by the exchange. The most cited example of an organized securities
exchange is the NYSE.
An over-the-counter (OTC) market is a network of brokers and dealers that interact electronically
without having a formal location.
Ex: The NASDAQ, which is a system for trading stocks, is the most visible example of the OTC market.
An organized securities exchange frequently uses specialists who facilitate trades in specific stocks.
In contrast, the NASDAQ has dealers who will execute your trades but also buy and sell securities
for their own account. Recently, electronic trading services have become quite popular and
provide yet another trading venue for publicly traded securities.
Private firms have only private equity investors. That is, if any part of a firm’s equity trades publicly,
we do not consider that firm to be “private.” Nonprivate or “public” firms have at least a portion
of their equity traded in public markets. A firm’s market capitalization (or “market cap”) is its
current stock price multiplied by the number of outstanding shares.
Bond Price Calculation
Assume that the government issues a two-year $1,000 bond with a current 6 percent market interest
rate. Also assume that interest is paid annually. A bond’s price would be set as follows:
If the interest rate on similar-maturity government bonds increases to 7 percent before the first interest
payment has been made on this two-year bond, its price will fall as follows:
Cost of Equity Capital for Public Corporations
capital asset pricing model (CAPM) developed during the 1960s and 1970s. Whether
the markets actually do reward investors in a manner consistent with the CAPM
remains a subject of ongoing research decades after its development.
The cost of equity capital has components similar to those in the cost of debt capital.
The cost of common equity (re) is determined by a risk-free interest rate (rf) plus a
risk premium for investing in the equity:
re = rf + IRP = RR + IP + IRP
where rf decomposes into a RR plus an IP. The investment risk premium (IRP) is the
additional return investors expect when investing in publicly traded common
stock. As with the cost of debt capital, the cost of equity capital starts with a
baseline of the default risk–free rate and adds premiums for various factors.
Cost of Equity Capital for Public Corporations
The CAPM can be used to estimate the cost of equity capital for firms that have previously gone public.
Specifically, the CAPM suggests an expected rate of return for a stock investment related directly to
the stock’s contribution to a specific well-diversified portfolio—the overall market. The expected
rate of return on a venture’s equity (re) using the CAPM security market line (SML) :
re = rf + [rm − rf]b
where rf is the risk-free interest rate, rm is the expected rate of return on the overall stock market for
the same time period, and b (called “beta”) is a measure of the stock’s risk contribution to a well-
diversified portfolio (the overall market portfolio). By construction, the beta for the overall market
is 1.00.
The usual practice in this calibration exercise is to use a historical estimate of (rm − rf) and current
interest rates for rf. In this exercise, the market risk premium (MRP) is the excess average annual
return of common stocks over government bonds. We can emphasize this approach by rewriting
the SML equation as:
re = rf + [MRP]b
For example, if we assume that the current risk-free interest rate on long-term government bonds is 6
percent, and we use 7 percent as reflecting the expected market risk premium, our expected
average annual rate of return on large-company stocks would be:
re = 6% + [7%]1.00 = 6% + 7% = 13%
A reasonable expected rate of return on large-company stocks would be about 13 percent. When risk-
free rates or market risk premiums are relatively low, expected returns for large-company stocks
also would be low.
Cost of Equity Capital for Private Ventures
Venture hubris
It is optimism expressed in business plan projections that ignore the possibility of failure or
underperformance.
The host of analysts digesting the diverse but related information provides some assurance that
the projections are reasonable. Because the firms have lengthy histories, the projections will
be less prone to the type of overconfidence or venture hubris exhibited in the financial
projections of many business plans.
When loaded into the return expectations, as an advisory premium (AP). Venture investors buy
securities that are not publicly traded and, therefore, bear the liquidity risk. Incorporating a
premium for this liquidity risk (LP), recognizing that compensation for advisory services is
loaded into return expectations, and allowing a hubris projections premium (HPP) when
dealing with hubris-influenced business plan projections, we can see that the rate of return
venture investors seek is:
rv = rf + IRP + AP + LP + HPP
= re + AP + LP + HPP
While we have seen that CAPM’s SML allows us to estimate the cost of equity for publicly traded
firms, estimating the cost of equity for ventures that are not publicly traded is much more
difficult.
IRP and therefore re (= rf + IRP) will generally be higher for private equity investments. Private
equity investors typically find it very difficult and costly to sell their positions. This leads to a
potentially large LP. On top of this, depending on the situation, venture investors may also
increase their target return for AP and overly optimistic business plan projections.
Weighted average cost of capital (WACC)
The weighted average cost of capital (WACC) is simply a weighted average of the cost of the
individual components of interest-bearing debt and common equity capital. The cost of
debt is the interest rate the venture pays for borrowed funds, adjusted for the fact that
interest is tax deductible.
Suppose we have a $1 venture that has issued $0.50 of debt and $0.50 of equity to
capitalize the $1 value. If the interest rate on debt is 10 percent, the tax rate is 30
percent, and the required return on equity is 20 percent, the after-tax weighted
average cost of capital is 13.5 percent. To see this, we can plug the numbers into the
formula:
After-Tax WACC = (1 - Tax Rate) * (Debt Rate) * (Debt to Value) + Equity Rate * (1 - Debt to Value)
= (0.70 * 0.10 * 0.5) + (0.20 * 0.5)
= 0.135; or 13.5%