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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
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