Evaluating financial options to fund a business
- Cost of capital Cost of debt
- Weighted Average Cost of Capital
- Financial gearing
The cost of capital is the rate of return that a business must pay to satisfy the providers of funds, and it reflects the riskiness of the funding transaction.
The cost of capital is the minimum rate of return that the investors (banking institutions, other lenders, private investors) require.
Where a solopreneur uses a mix of capital (debt and personal financial investment), the overall cost of capital might be taken to be the weighted average of the cost of each type of capital..
Ultimately, each business will endeavour to find the correct combination of debt and capital investment (e.g. reinvest your profits or your own savings) that will allow it to perform and meet market expectations. One of the most important factors to consider is the monthly/annual debt obligation. What is the loan interest repayable each year and will you have enough cashflow to cover that repayment whilst still being able to meet other demands? In recent years, debt capital has been available at a historically low rate, however, the loans can come with restrictions, reporting obligations and financial institutions tend to be more risk averse.
Financial gearing relates to the percentage of debt used to finance a business. The higher the percentage, the more highly geared the business is. Some financial institutions will be cautious if you are highly geared, as it indicates that you have existing debt obligations. In recent years, one of the primary factors in determining loan approval has been the ‘debt repayment capacity’. This is a measure of your ability to repay a monthly/annual loan based on your current net income.
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