Introduction
As the world becomes a global village, with technological advancements and liberalization of trade, many people in the business world are trying to increase and expand their market share whether locally or internationally. Whatever the case when one is seeking a new investment opportunity, extra sources of capital is required to fund the new promising investment opportunities. The main aim for any new investment is to make profits through big organizations that have got other roles to fulfill such as social responsibility and increasing the market share within the economy.
The new sources of capital come together with different costs which are associated with the source and the procedure of acquiring the capital. In spite of many investors thinking that interest on capital is the only cost of capital the transaction costs are involved when one is seeking the extra funds and thus it becomes very hard to quantify the cost of capital because some of the transaction costs are hidden.
Many among the world micro economists believe that monetary investment policies affect investment into new opportunities. However, to the applied researchers, it has been hard for them to find any significant effect of the cost of capital on investment. This brings to the suggestion that maybe monetary policies work through broad credit channels rather than on interest rates alone. Since it is the belief of many that the cost of capital is a critical element in business decisions, this brings to the issue of how far does the cost of capital influences investment into new opportunities (Chartelain & Tiomo, 2001). The cost of capital is the expense incurred by the company when seeking new investment opportunities.
Those extra costs above what you get which you have to repay when settling the capital are the cost of capital. Some argue that neither the interest rates which is the cost of capital nor the cost of equities alone that can provide a good measure or degree level of the facts about the cost of capital. This is due to the reason that as the proportions of debts and equities in a company’s balance sheet change so do the risks involved also change. For example, if a country like the United States of America is experiencing increased inflation, there will be a transfer of real wealth into equities and this will make debts in the real sense seem more expensive than what they are in reality while making the equity appears as cheap. The reverse should be expected if the inflation rate is low (Mirakhor, 1996).
The cost of capital (an interest) has effect on the value of any new opportunity that an investor may seek to invest in, is due to the fact that an individual’s purchasing power is either increased or decreased with fluctuations of the interest rates for example when the interest rates are high, extra capital acquired will be less due to the high costs involved. Interest rates affect the capital flow in the market by shifting the supply and demand of capital available thus driving the costs up and down. It is not the only factor that determines investment into new opportunities rather many other factors also come to play. In order to understand how the cost of capital affects investment into new opportunities; one also needs to understand how capital flows and financing rates also affect investment into new opportunities (Stammers, n.d).
Purpose of the Study
The study will try to research whether the cost of capital is or is not a critical element in the decision making process when sourcing for external sources of capital as well as how it influences investment into new opportunities in a business organization. The study will also try to cover the different sources of capital and the costs of capital involved.
Background
To expand or remain in the same business position depends on a number of factors and involves an involving decision-making process. While it is advisable for businesses to expand or preserve their market niche by increasing their investments other issues ranging from the competition and the market conditions influences the urge to expand or remain stuck in the same position. The challenges which come up with new investments are most of the times the hindrance to expansion.
The cost of capital is among the biggest challenges that face any investor with an idea of investing. There exists different sources of capital ranging from equities, debts or own contribution and these different sources of capital involve different forms of capital costs. For anyone in dire need of investing the above sources should be investigated well and the combination with the least expenses should be the most approachable.
Literature Review
The different economic conditions affect how easy or how difficult it is to be successful because of their effect on both availability and cost of capital. A smooth flow of capital induces less capital costs and when the costs of capital involved are less, it is usually attractive for anyone wanting to invest. This is in line with the optimistic mind that in future there will be growth and the current investments will be profitable. The opposite happens when the capital available in the market is less and thus the costs of acquiring are high. The expected growth will be minimal and profitability will be low.
In the process of understanding the best combinations when seeking for external funds to invest in a new opportunity, various approaches can be used and the decision unto source should always be based on risks involved and the costs incurred in the process. Many economists advise that the best combination should be the one that mixes both debts and equities that maximizes the value to the firm at the same time maintaining a low cost of capital.
There are two approaches in reaching the best mix of a capital structure. The first approach is called the net operating income and it assumes that no matter how you mix the capital structure, the value of the business is not primarily determined by the mix of capital structure but by the capitalization of operating income. In contrast to the second type of approach the Net operating income approach which concludes that the capital structure of an organization has a major influence on the value of the organization therefore by using capital sources such as debts, it changes both the cost and the value of the firm. The net income is capitalized by arriving at the market value of the firm.
Among the factors that one should consider when determining the source of the additional capital required includes the flexibility of the source, the risk involved, income expected, and the control one will have in the business among other factors. Since the present decision making will affect tomorrow’s financing it is advisable for one not to rely on debts as too much debts and external equities might influence heavily the decision making process and thus the need for a flexible source of capital. For the risk factor, when using debt as a source of capital there is limit as to how much debt we can use to finance for our business because with high debts the risk involved also increases (Evans, n.d).
Options of Financing
Equity financing
Most of the times this process seeks non governmental financing in the absence of security resources. The advantages of this type of financing are that the investors risk is partly reduced while the required capital is adequately raised. The limited mode of financing reduces dispersion of management rights and it combines the advantages of conventional equity financing and debit and credit. This financing mode provides new opportunities for the financing of small and medium sized enterprises that most of the time make the largest part of our population.
Trust financing
This method of financing works through established fund systems as a way in which capital for new opportunities can be sourced. This type of funding has its advantages as it can connect all kinds of financial instruments. The method has greater flexibility and can design personalized trust products in accordance with the specific needs required. It optimizes capital structure without raising the assets and liabilities ratio enterprise. In matters about Capital cost, the capital cost of trust financing is lower than that of equity financing and it can take the fixed rate of debt, thus reflecting the advantages of debt financing. It also has higher rights than debt financing reflecting the advantages of equity financing (Zhang, Xinwang & Chao, n.d).
Listing
Involves listing one’s company or organization to the public sector. The financial and capital cost of listing is usually lower than the cost of loan and thus it can optimize administration structure and management abilities, enlarge enterprises brand influence and still increase credit access by turning into a public company. Most of the times, Initial Public Offers (IPOS) are characterized by less time faster process and low capital costs but it has high risks and it needs higher net assets income ratio (Zhang, Xinwang& Chao, n.d.).
In the United States of America when a company is listed in the stock exchange, it is usually committed to more extensive and strictly reinforced disclosure standards. The increased disclosure is aimed at reducing information asymmetries and lower the firms cost of capital (Hail & Leuz, 2005). Hail and Leuz (2005) further asserts that with strong security regulation and the demanded disclosures there will be lower costs of capital due to the broadened investment base and the reduced chances of moral hazard and adverse selection. Thus, we can argue listing not only enhances cash flow but also it influences the cost of capital.
Private equity
This is a way of selling securities to specific investors from financial sector or to individuals who most of the time do a lot of their businesses with sponsors. It is a good way of sourcing for extra capital as it raises money quickly and saves time and in most countries there is no need for registration thus saving the registration fees also. However, its capital flow is slow and this makes the capital cost be so high due to the restriction of the number of shareholders who can be involved.
The advantages of using stocks or equities include the fact that no fixed payments are required and dividends are paid according to the earnings thus there is no fixed cost of capital. The other advantage is that there is no maturity date on the security as the invested capital does not have to be paid and it also improves the credit worthiness of the company. While among the disadvantages of investing in equities is that it dilutes the earning per share to the owner as the profits earned have to be allocated according to the proportion of the equities
Debt Financing
This takes place when one seeks to have all the extra capital required to be from borrowings. The main essence of borrowing is that the debtor must repay the funds along with an agreed rate if interest. Seeking capital from outside is a hefty procedure but can be made easier if the two parties already know each other. For the relationship between the debtor and the creditor, money should never be borrowed lightly rather the borrower should ensure the funds he or she is seeking will yield proceeds enough in excess of their cost.
Debts can be in form of small business administration loans, Long-term loans, Line of credit or even loans from friends and family among other sources. Sourcing capital from debts also has its advantages among them being that the interest payments are not tax deductible and the expected returns to investors are usually lower than the stock thus the creditors earns a fixed portion of income in contrast to the equities. The main disadvantage is that the fixed charges have to be paid in regardless of how the business is behaving thus adding more risk to the business.
With the above sources already described, the cost of capital to a firm or to an individual who seeks to acquire assets whose yields are uncertain can be obtained from different sources ranging from pure debts instruments to pure equity. It should be noted that a physical asset is worth acquiring if it will increase the net profit of the owner but net profits in ordinary situations increase if the yield of the assets is more than the interest rate. Whether pure debts or pure equities, the cost of capital is always equal to the interest on bonds regardless of how the funds were got. According to Nakana, when quoting Modigliani and Miller
In a world of sure returns, the distinction between debt and equity funds is non-existent. It must however be acknowledged that we live in a world in which nothing is certain. With the recognition of uncertainty the equivalent implications disappears. In fact, the profit maximization criterion is no longer even well defined. Under uncertainty there corresponds to each decision of the firm not a unique profit outcome, but a plurality of mutually exclusive outcomes which can at best be described by a subjective probability distribution (pg28)
Thus, it is advisable for anyone when seeking for the extra capital to be aware of the risks involved and must calculate well the requirements rather than in the end result in losing even what one owned before.
The cost of capital is influenced by the following conditions
- Economic Conditions: The capital supply and demand in the market influences how the capital is raised and thus influencing the way the cost of capital sways. For example, in the macroeconomic arena if the inflation rate is expected to rise more capital will be invested and thus raising the capital demanded which will result in the cost of capital rising. The reverse happens when the rates of inflation are expected to go down.
- Market Conditions: if the market demands higher rate of return from capital the same thing will happen to the cost of capital. Thus, the forces of demand and supply will come to play. For example if capital is raised with a security that does not have a high demand, investors will require higher rates of return for the increased risk
- Operating Conditions: For a business to have a high cash flow, the current assets should be more than the fixed assets in order to ensure that the operating capital is high enough to enhance increased competition and higher economic growth. When there is adequate capital to run the business the risk involved will be less and there will be no need to liquidate some of the assets in order to get the required cash. The costs of capital involved also depend with the countries involved. That is the reason why some investors opt for production abroad instead of exporting. They are usually motivated by cheaper capital costs, the economies of scale, and the transaction costs involved (Shintzer & Marin, 2005).
Findings and Analysis
For a new business investment the chances of having enough capital is always rare and thus there is always need to source capital from outside the business. The different sources of capital that exist as we have discussed in the literature review demand different costs. For example, sometimes if the business owners could lease or borrow all the capital required it would be much better and most investors probably would be in more debt that they are as of now. If small business owners leased or borrowed all the capital they needed they would be much better off making higher profits but the main barrier to all this is the cost of capital involved.
Other business owners also think that by using their own earning it is cheaper since no interest is paid. What they forgets is that using own earnings demands more sacrifices than using equities or debts to finance for a new investment opportunity. For example when you think about taxation then you better not place own earnings as a source of capital. Earnings are always taxed by the government when one uses own earnings as capital, the government will still require him or her to pay capital taxes. When the capital used is finally invested and yields profits the government will still require you to pay tax profits and thus when observed in a closer perspective you will end up losing more than if you had used debts.
When the above is compared with using debts or equities, interest and lease payments are deducted as business expenses and thus they are not taxed. If you use a debt then you get to deduct depreciation against income. Thus, it is important to note that most governments encourage the use of capital and equities by allowing one to deduct depreciation and interest in income financial statements. Whenever you borrow though it attracts interest it does not attract tax but whenever you earn you have to pay taxes. So it’s your decision how you want to restructure your capital sources (Lindsay, nd.).
According to Bassen, Holz, and Schlange (2006) the relationship between social and financial measures are there though the variables that influence the relationship are many thus if we specify the costs of capital as the only major factor that influence investment into new opportunities investment we may suffer from specification errors thus there is a need to conduct a study which would involve cost of capital and other factors to know the extent of the relationship.
Conclusion
The objective or the purpose of the study was determining whether the cost of capital affects investment into new opportunities. The evidence which has been produced is conflicting as the different sources of capital make the investor incur different forms of expenses. The study has also concluded that other factors such as moral hazard and the transaction costs involved when one is looking for new capital sources also influence the investment into new opportunities.
Thus, we can conclude that depending on the different economic conditions or environment one is exposed to, there will be different costs of capital to be incurred. It is imperative to evaluate them according to the opportunities and risks involved and the one which has the minimum risk but with higher returns should be sought. Thus, it would be my advice that when one is seeking new capital sources one should include all the expenses and the other factors in consideration so as to avoid making unnecessary losses.
References
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Chatelaine, J; Tiomo, A. (2001). Investment, the Cost of Capital, And Monetary Policy in the Nineties in France. Web.
Evans, H. M. (n.d). The management of capital. Web.
Hail, L; Leuz, C. (2005). Cost of Capital and Cash Flow Effects of U.S. Cross-Listings. University of Pennsylvania. Web.
Lindsay, J. (n.d). The difference between debt and equity financing. Web.
Marin, D. & Schnitzer, M. (2005). When is FDI a Capital Flow? Web.
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Nakana, E. (2009). Analysis of capital sources, owner objectives, and determinants of performance of wine farms in the Western Cape. Web.
Schaller, H. (2010). Investment, Taxes and the Cost of Capital: An Euler Equation Specification Test. Department of Economics, Carleton University, Canada. Web.
Stammers, R. (Not Dated). How interest rates affect property values. Web.
Zhang, Z; Xinwang, Z; Chao, D. (n.d.). The Financing Options of Real Estate Companies under Macro-control of China. Web.