TYPES AND COSTS OF FINANCIAL CAPITAL 1 ENTREPRENEURIAL FINANCE

 Interest Rate: price paid to borrow funds  Default Risk: risk that a borrower will not pay the interest and/or principal on a loan 2

 Nominal Interest Rate (r d ):  observed or stated interest rate  the rate quoted in loan and deposit agreement  Real Interest Rate (RR): interest one would face in the absence of inflation, risk, illiquidity, and any other factors determining the appropriate interest  Is the growth rate of purchasing power derived from an investment.  Real Interest Rate = Nominal Interest Rate – Inflation  Example: Earn 4% from saving account ; inflation 3% ; Real Interest Rate = 4% - 3% = 1%  Risk-free Interest Rate (r f ): interest rate on debt that is virtually free of default risk  Inflation:  Rising prices not offset by increasing quality of the goods or services being purchased  A rate at which the general level of prices for goods and services is rising but purchasing power is falling  Every dollar will buy smaller percentage of good 3

 Inflation Premium (IP): average expected inflation rate over the life of a risk-free loan  Default Risk Premium (DRP):  additional interest rate premium required to compensate the lender for the probability that a borrower will default on a loan  the higher the quality of the loan, the lower the DRP, thus, lower nominal interest rate  Liquidity Premium (LP): charged when a debt instrument cannot be converted to cash quickly at its existing value  Maturity Premium (MP): premium to reflect increased uncertainty associated with long- term debt 4

 r f = RR + IP for debt by effectively default-free borrowers (e.g. U.S. government)  r d = RR + IP + DRP +LP +MP more generally, for more complicated risky debt securities at various maturities and liquidities  r d = r f + DRP + LP + MP 5

 r d = RR + IP + DRP +LP +MP  Suppose:  Real interest rate = 3%  Inflation expectation = 3%  Default risk = 5%  Liquidity premium = 3%  Maturity premium = 2%  Then:  r d = 3% + 3% + 5% + 3% + 2% = 16% 6

 Dividend Growth Model Approach 7

8

9

 The Security Market Line Approach  Depends on three things ▪ The risk free rate, rf ▪ The market risk premium, E(Rm) – rf ▪ The systematic risk of the asset relative to average, which called Beta Coefficient, β  E(Re) = rf +βe x (E(Rm) – rf) ▪ Example: rf : 0.2% ; βe : 1.1 ; market premium : 7% ▪ E(Re) = 0.2% x 1.1 (7%) = 7.9% 10

11  Assume the previous example in SML:  Do = $0.05  g = 9.45%  Po = $2.41  With Dividend Growth Model:  D1 = Do (1+g) = 0.05 ( ) =  Re = D1 / Po + g = = 11.72%  Average cost of equity (SML and dividend approach)  Re average = (7.9% % ) / 2 = 9.81%

 WACC: weighted average cost of the individual components of interest- bearing debt and common equity capital  V = E + D  E = Equity ; D = Debt  100% = E / V + D / V  WACC = (E/V) x Re + (D/V) x Rd x (1 – Tc)  Tc = Tax Rate 12

 Example:  E = $7.152 million ; D = $2.516 million  V = =  E / V = / =  D / V = / =  Re = 7.06%  Rd = 3.43%  Tc = 18%  WACC = (7.06%) (3.43%) (1-0.18) = 5.22% % = 5.95% WACC for the company is 5.95% 13

 If more than 1 debt / cost of debt  E/V = 0.83  D/V = 0.17  Tc = 18%  Re = 10.43%  Rd = 1.65%  WACC = 0.83 (10.43%) (1.65%)(1-0.18) = 8.66% % = 8.89% 14

15