finacial management

1. DEFINE COST OF CAPITAL. WHAT ARE
THE VARIOUS SOURCES OF FINANCE
AVAILABLE TO A BUSINESS
ENTREPRENEUR? HOW THEY CAN BE
ESTIMATED?
MOHIT VERMA
BBA 4TH
SEMESTER
01915101718

2. WHAT IS COST OF CAPITAL?
• COST OF CAPITAL REFERS TO THE OPPORTUNITY COST OF MAKING A
SPECIFIC INVESTMENT. IT IS THE RATE OF RETURN THAT COULD HAVE BEEN
EARNED BY PUTTING THE SAME MONEY INTO A DIFFERENT INVESTMENT WITH
EQUAL RISK. THUS, THE COST OF CAPITAL IS THE RATE OF RETURN REQUIRED
TO PERSUADE THE INVESTOR TO MAKE A GIVEN INVESTMENT.

3. HOW COST OF CAPITAL WORKS (WITH
EXAMPLE)
• COST OF CAPITAL IS DETERMINED BY THE MARKET AND REPRESENTS THE DEGREE
OF PERCEIVED RISK BY INVESTORS. WHEN GIVEN THE CHOICE BETWEEN
TWO INVESTMENTS OF EQUAL RISK, INVESTORS WILL DETERMINE THE COST OF
CAPITAL AND GENERALLY CHOOSE THE ONE PROVIDING THE HIGHER RETURN.
• LET'S ASSUME COMPANY XYZ IS CONSIDERING WHETHER TO RENOVATE ITS
WAREHOUSE SYSTEMS. THE RENOVATION WILL COST $50 MILLION AND IS EXPECTED
TO SAVE $10 MILLION PER YEAR OVER THE NEXT 5 YEARS. THERE IS SOME RISK
THAT THE RENOVATION WILL NOT SAVE COMPANY XYZ A FULL $10 MILLION PER
YEAR. ALTERNATIVELY, COMPANY XYZ COULD USE THE $50 MILLION TO BUY
EQUALLY RISKY 5-YEAR BONDS IN ABC CO., WHICH RETURN 12% PER YEAR.

4. HOW COST OF CAPITAL WORKS (WITH
EXAMPLE)…….
• BECAUSE THE RENOVATION IS EXPECTED TO RETURN 20% PER YEAR
($10,000,000 / $50,000,000), THE RENOVATION IS A GOOD USE OF CAPITAL,
BECAUSE THE 20% RETURN EXCEEDS THE 12% REQUIRED RETURN XYZ COULD
HAVE GOTTEN BY TAKING THE SAME RISK ELSEWHERE.
• THE RETURN AN INVESTOR RECEIVES ON A COMPANY SECURITY IS THE COST OF
THAT SECURITY TO THE COMPANY THAT ISSUED IT. A COMPANY'S OVERALL
COST OF CAPITAL IS A MIXTURE OF RETURNS NEEDED TO COMPENSATE ALL
CREDITORS AND STOCKHOLDERS. THIS IS OFTEN CALLED THE WEIGHTED
AVERAGE COST OF CAPITAL AND REFERS TO THE WEIGHTED AVERAGE COSTS OF
THE COMPANY'S DEBT AND EQUITY.

5. WHY COST OF CAPITAL MATTERS
• COST OF CAPITAL IS AN IMPORTANT COMPONENT OF BUSINESS VALUATION
WORK. BECAUSE AN INVESTOR EXPECTS HIS OR HER INVESTMENT TO GROW
BY AT LEAST THE COST OF CAPITAL, COST OF CAPITAL CAN BE USED AS A
DISCOUNT RATE TO CALCULATE THE FAIR VALUE OF
AN INVESTMENT'S CASH FLOWS.
• INVESTORS FREQUENTLY BORROW MONEY TO MAKE INVESTMENTS,
AND ANALYSTS COMMONLY MAKE THE MISTAKE OF EQUATING COST OF
CAPITAL WITH THE INTEREST RATE ON THAT MONEY. IT IS IMPORTANT TO
REMEMBER THAT COST OF CAPITAL IS NOT DEPENDENT UPON HOW AND
WHERE THE CAPITAL WAS RAISED. PUT ANOTHER WAY, COST OF CAPITAL IS
DEPENDENT ON THE USE OF FUNDS, NOT THE SOURCE OF FUNDS.

6. WHAT ARE THE VARIOUS SOURCES OF
FINANCE AVAILABLE TO A BUSINESS
ENTREPRENEUR?
• SOURCES OF FINANCING FOR SMALL BUSINESS OR STARTUP
CAN BE DIVIDED INTO TWO PARTS: EQUITY FINANCING
AND DEBT FINANCING. SOME COMMON SOURCE OF
FINANCING BUSINESS IS PERSONAL INVESTMENT, BUSINESS
ANGELS, ASSISTANT OF GOVERNMENT, COMMERCIAL
BANK LOANS, FINANCIAL BOOTSTRAPPING, BUYOUTS.

7. SOURCES OF FINANCING BUSINESS
BEST COMMON SOURCES OF FINANCING YOUR BUSINESS ARE:
• PERSONAL INVESTMENT OR PERSONAL SAVINGS
• VENTURE CAPITAL
• BUSINESS ANGELS
• ASSISTANT OF GOVERNMENT
• COMMERCIAL BANK LOANS AND OVERDRAFT
• FINANCIAL BOOTSTRAPPING
• BUYOUTS

8. FINANCIAL BOOTSTRAPPING
• HERE THE GOAL REMAINS TO BUILD A SUSTAINABLE BUSINESS COMPRISING OF
COMMITTED EMPLOYEES AS WELL AS A GROWING CUSTOMER COMMUNITY
WITHOUT HAVING TO SEEK OUT THE ASSISTANCE OF A BANK LOAN.
• VARIOUS EXAMPLES OF FINANCIAL BOOTSTRAPPING ARE SWEAT EQUITY, OWNER
FINANCING, JOINT UTILIZATION, MINIMIZATION OF ACCOUNTS PAYABLE,
DELAYING PAYMENT, MINIMIZATION OF INVENTORY, SUBSIDY FINANCE ETC.

9. BUYOUTS
• THIS FORM OF CORPORATE FINANCE CAN ALTER THE FORM OF A
COMPANY’S OWNERSHIP. AFTER THE COMPANY ATTAINS A PRIVATE STATUS BY
BEING FREED FROM THE REGULATORY BURDENS OF OPERATING AS A PUBLIC
FIRM, THE ULTIMATE GOAL OF BUYOUT REMAINS TO BUILD ITS VALUE.
• SELLING OFF NON-CORE ASSETS, REFOCUSING ON THE MISSION OF THE
COMPANY, STREAMLINING PROCESSES, FRESHENING PRODUCT LINES AND
REPLACING EXISTING MANAGEMENT MIGHT THUS SERVE AS ESSENTIAL PARTS OF
THE BUYOUT DRIVE.

10. BUSINESS ANGELS
• THESE ARE THE PROFESSIONAL INVESTORS WHO INVEST EITHER JUST A PART OR
THEIR ENTIRE WEALTH AS WELL AS TIME IN THE GROWTH OF INNOVATIVE
COMPANIES.

11. VENTURE CAPITAL
• UNDER THIS FORM OF CORPORATE FINANCING, THE FINANCIAL INVESTOR
PARTICIPATES IN THE FRESH BUSINESS IN EXCHANGE FOR STRATEGIC ADVICE
AND CASH.
• VENTURE CAPITALISTS ARE THUS ON THE LOOKOUT FOR COMPANIES HAVING
HIGH GROWTH POTENTIAL, TOP-PERFORMING MANAGEMENT TEAMS AND LOW
LEVERAGE CAPACITY.

12. LOANS & OVERDRAFT
• BANK LOANS SERVE AS A LONG-TERM MODE OF FINANCING ENTREPRENEURIAL
BUSINESS. OVERDRAFT FACILITY IS FOR A SHORT-TERM SPAN. UNDER A BANK LOAN,
THE FINANCIAL INSTITUTION SHALL SPECIFY THE LOAN TENURE.
• AS WELL AS THE TIMING, AMOUNT OF REPAYMENTS AND INTEREST RATE. THE
ENTREPRENEUR GIVES SOME COLLATERAL IN EXCHANGE FOR THE BANK LOAN. IT
SERVES AS THE IDEAL CHOICE FOR FINANCING FIXED ASSET INVESTMENTS.
• THEY OFFER A LOWER INTEREST RATE COMPARED TO A BANK OVERDRAFT.
HOWEVER, THEY DO NOT RANK HIGH IN THE DEPARTMENT OF FLEXIBILITY.
• A BANK OVERDRAFT CAN BE OF ASSISTANCE WHEN THE BANK BALANCE OF
ENTREPRENEURS FALL BELOW THE MINIMUM LEVEL. AND THEY CAN BORROW SOME
MONEY FROM THE BANK ITSELF IN EXCHANGE OF A HIGH-INTEREST RATE. THEY ARE
THUS IDEAL FOR DEALING WITH SEASONAL CASH FLOW FLUCTUATIONS OR WHEN
THE BUSINESS FACES A SHORT-TERM LIQUIDITY CRISIS.