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Chapter 7
TYPES AND COSTS OF FINANCIAL CAPITAL
FOCUS
In this chapter, we characterize financial markets and focus on developing an understanding of
the how one obtains and pays for financial capital. Without adequate capital, even the best
ideas and ventures cannot succeed. The cost of debt is relatively easy to understand and apply
because it is primarily captured in the stated interest rate for a loan or bond. In contrast, the
cost of equity is more difficult to grasp. One typically pays only a small part, if any, of the cost
of equity through cash payments (dividends). More often, the majority, if not all, of the cost of
equity is “paid” to the providers of equity capital by increases in the value of equity (capital
gains).
LEARNING OBJECTIVES
1. Understand some of the basic characteristics of the financial markets.
2. Understand how risk-free securities prices reflect risk-free borrowing rates.
3. Explain how corporate debt prices reflect higher interest rates when a borrower may
default.
4. Explain investment risk.
5. Estimate the cost of publicly traded equity capital (e.g., exchange-listed common stocks).
6. Estimate the cost of private equity capital.
7. Explain how capital costs combine into a weighted average cost of capital (WACC).
8. Understand venture investors’ target returns and their relation to capital costs.
CHAPTER OUTLINE
7.1 IMPLICIT AND EXPLICIT FINANCIAL CAPITAL COSTS
7.2 FINANCIAL MARKETS
7.3 DETERMINING THE COST OF DEBT CAPITAL
A. Determinants of Market Interest Rates
B. Risk-Free Interest Rate
C. Default Risk Premium
D. Liquidity and Maturity Risk Premiums
E. A Word on Venture Debt Capital
7.4 WHAT IS INVESTMENT RISK?
A. Measuring Risk as Dispersion around an Average
B. Historical Return Versus Risk Relationships
7.5 ESTIMATING THE COST OF EQUITY CAPITAL
A. Cost of Equity Capital for Public Corporations
B. Cost of Equity Capital for Private Ventures
C. Sources and Costs of Venture Equity Capital
7.6 WEIGHTED AVERAGE COST OF CAPITAL
A. A Life Cycle-Based WACC Example
SUMMARY
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APPENDIX A:
Using WACC to Complete the Calibration of EVA
DISCUSSION QUESTIONS AND ANSWERS
1. Describe how the costs of debt and equity differ from the perspective of accounting
measures.
While accountants recognize that financial capital has a cost and recommend its complete
2. How do private and public financial markets differ?
3. Briefly describe venture debt capital and venture equity capital.
In general, early-stage ventures raise debt capital from individuals, venture lenders, and
4. What is an interest rate? What is default risk?
5. What is a nominal interest rate? Describe a risk-free interest rate and a real rate of
interest.
6. Define inflation. What is meant by an inflation premium?
7. Define the term default risk premium.
8. What is meant by a prime rate?
9. What is a bond rating?
10. What is a liquidity risk premium? What is a maturity risk premium?
11. What is meant by the term structure of interest rates? What is a yield curve?
12. Describe the differences between senior debt and subordinated debt.
13. Explain the meaning of investment risk of loss and describe how risk can be defined
relative to an average value.
20. How do we estimate the cost of equity capital for private ventures? In developing your
answer describe the major components that are considered when estimating the rates of
return required by venture investors.
21. What discount rates are typically used for development- stage, startup-stage, survival-
stage, and early-growth-stage ventures?
22. What is meant by the weighted average cost of capital or WACC?
23. How is a venture’s WACC likely to change as it moves through a successful life cycle?
24. From the Headlines—Ecosphere: You have been retained as a consultant for Ecosphere and
tasked with assessing the financial viability of their commercial ventures. What types of
financial ratios would you enlist in your report to Ecosphere? What approach would you
take to determining a relevant cost of capital for those ventures?
Answers will vary: Ecosphere has a great deal of variety in the types of products and
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INTERNET ACTIVITIES
1. Access the Federal Reserve Board of Governors web site at
http://www.federalreserve.gov/releases/ to find current interest rates (and foreign
exchange rates) relevant for your business venture.
Web-researched results vary due to constant updating of the related web sites.
2. Access http://www.bloomberg.com for interest rates and financial market news.
Summarize the current financial market conditions.
Web-researched results vary due to constant updating of the related web sites.
3. Access http://www.pwcmoneytree.com for a summary of recent venture capital investment
performance. Summarize the return experience for the various venture-investing rounds.
Web-researched results vary due to constant updating of the related web sites.
EXERCISES/PROBLEMS AND ANSWERS
1. [Inflation and Risk Premiums] Voice River, Inc. provides media-on-demand services via the
Internet. Management has been studying current interest rates. A lender is willing to make
a two-year loan to Voice River at a 12 percent annual interest rate. The U.S. government
is currently paying 8 percent annual interest on its two-year securities.
A. If the real rate of interest is expected to be 3 percent annually, what is the inflation
premium expected at this time?
B. What is the amount of the total risk premium that Voice River will have to pay?
C. If a 1 percent liquidity premium is built into the 12 percent rate, what is the default risk
premium on the loan?
2. [Maturity and Default Risk Premiums] Following is interest rate information currently
being observed by the Electronic Publishing Corporation.
One-year U.S. government securities 4.5%
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One-year bank loans 6.0
Five-year U.S. government securities 7.0
Five-year bank loans 9.5
A. What is the amount of the maturity risk premium on one-year versus five-year U.S.
government securities?
B. What is the amount of the maturity risk premium on one-year versus five-year bank
loans?
C. What is the default risk premium on one-year bank loans and on five-year bank loans?
5 Year; 9.5% – 7% = 2.5%
3. [Expected Rate of Return and Risk Measures] A venture investor, BKAngel, is considering
investing in a software venture opportunity. However, the rate of return to be realized next
year is likely to vary with the economic climate that actually occurs. Following are three
possible economic outcomes, the probability that each one will occur, and the rate of
return projected for each outcome:
Economic Probability of Rate of
Climate Occurrence Return
Recession .25 -20.0%
Normal .50 15.0
Rapid Growth .25 30.0
A. What is the expected rate of return on the software venture?
B. Calculate the variance and standard deviation of the rates of return for the software
venture?
C. Calculate the coefficient of variation of the rates of return for the software venture. If
the coefficient of variation of rates of return for BKAngel’s prior venture investments is
1.5, would the software venture be considered as being less or more risky?
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4. [Expected Rate of Return and Risk Measures] A potential venture investment has the
following possible outcomes:
Performance Probability of Rate of
Outcome Occurrence Return
A. What is the expected rate of return on the venture?
B. Calculate the variance and standard deviation of the rates of return for the venture.
C. Calculate the coefficient of variation of the rates of return for the venture. If the
coefficient of variation of rates of return for your prior venture investments is 4.0,
would the new venture be considered as being less or more risky?
5. [Portfolio Expected Rate of Return and Risk Measures] Three venture investments
previously made by BKAngel, a venture investor, achieved the following outcomes for the
year just completed:
Venture Initial Cash Ending
Opportunity Value Flow Value
A. Calculate the percentage rate of return for each of the venture investments.
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B. Calculate an expected rate of return for a “portfolio” of these three venture
investments “weighted” by each venture’s investment share of a total $1,000,000
investment.
C. Calculate the variance and standard deviation of the rates of returns for the portfolio
investment.
D. Calculate the coefficient of variation of the rates of returns for the portfolio investment.
Is this portfolio investment less or more risky than another investment opportunity with
a coefficient of variation of 1.5?
6. [Portfolio Expected Rate of Return and Risk Measures] Refer to Problem 5. Assume that
BKAngel’s initial investments in the three ventures had been Venture 1 = $500,000,
Venture 2 = $300,000, and Venture 3 $200,000 with each investment having achieved the
same cash flows and ending values shown in Problem 5.
A. Calculate the percentage rate of return for each of the venture investments.
% Return = (cash flow + ending value – beginning value)/(beginning value)
B. Calculate an expected rate of return for a portfolio of these three venture investments
weighted by each venture’s investment share of a total $1,000,000 investment.
C. Calculate the variance, standard deviation, and coefficient of variation of the rates of
returns for the portfolio investment.
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7. [Loan Present Values] Jerry’s Tree Services is trying to raise debt funds from a
prospective venture investors, SureWay LLC. SureWay indicated to Jerry Lau that the
annual interest rate on risky venture loans is currently 15 percent. Jerry is seeking a 3-
year loan with annual payments. He is willing to pay back $100,000 at the end of 3 years.
However, due to cash flow problems, he can afford to pay interest at a 12 percent annual
rate.
A. Calculate the dollar amount that SureWay venture investors would lend to Jerry’s Tree
Services.
B. What would be the dollar amount of the loan if the loan was made for only two years?
8. [Loan Present Values] Refer to Problem 7. Show how your answer to Part A of Problem 7
would change if Jerry were willing to pay 16 percent annual interest and a principal
payment of $100,000 at the end of three years.
9. [Expected Rate of Return and Hubris Premiums] Following is rate of return component
information for FirstVenture investors.
Rate Return
Component Component
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A. Calculate the expected rate of return before considering premiums for illiquidity,
advisory activities, and hubris projections.
B. Estimate the hubris projections premium for this FirstVenture investment.
Hubris projections premium = 40.0% – 17.5% – 5.5% – 9.0% = 8.0%
10. [Cost of Equity Capital] Use the following information to estimate the rate of return
expected by the VentureBanc Investors:
Rate Return
Component Component
Liquidity Premium 5%
Risk-free Rate 6
Advisory Premium 9
Market Risk Premium 7.5
Hubris Projection Premium 15
A. VentureBanc uses a systematic risk measure of 2.0. Based on the information shown,
estimate VentureBanc’s investment risk premium. Then, estimate the cost of equity
capital for VentureBanc.
B. Determine the rate components and their returns that a venture investor like
VentureBanc would require to be covered beyond a traditional cost-of-equity estimate.
C. What overall venture investment discount rate would be used by the VentureBanc?
11. [Weighted Average Cost of Capital] Kareem Construction Company has the following
amounts of interest-bearing debt and common equity capital: