Is your business looking to raise more capital?
Whether you’re an emerging startup or an established SME, securing funding allows you to successfully scale and grow your business.
There are many ways to get your hands on capital, but funding almost always comes at a cost.
Understanding these costs can help you choose the right investment options for your business and maximise your returns. While some investment options may appear attractive on the surface, the costs can quickly spiral once you dig a bit deeper.
Join us as we explore the cost of capital and explain how your business can raise funds without breaking the bank.
What is the Cost of Capital?
Cost of capital is the opportunity cost associated with raising funds for your business.
In layman’s terms, cost of capital is the rate of return an investor requires to part with their cash. Cost of capital tends to be high for risky investments and lower for safer ones.
To avoid too much finance jargon, we can compare the cost of capital to horse racing.
- If you bet on the favourite, you can expect a relatively small return on your investment.
- If you gamble on a wildcard, the chances of winning are low. However, the payout will be huge if your horse is first across the line.
When choosing between two equally risky investments, investors will calculate the cost of capital and opt for the investment which offers the highest yield.
Why is Cost of Capital Important?
Investors will use the cost of capital as a discount rate to calculate the value of your business. Whether you’re pitching to an angel investor or applying for a bank loan, investors ideally want to find projects with a faster growth rate than the expected cost of capital.
Crucially, the cost of capital is independent of the initial investment. Instead, cost of capital is often determined based on how the funds are used to generate a return.
To give an example, let’s imagine your business is planning to expand by moving into a new office.
- The new office costs £1 million, and there’s a 90% chance it will save your business £200K each year for the next five years. That’s a 20% year-on-year return.
- However, you’re also considering an acquisition opportunity which involves buying a local SME for £500K.
- Based on their balance sheet, you estimate that the chance of the acquisition generating a return of £100K per year over the next five years is only 70%.
- While both investments have a year-on-year return of 20%, the cost of capital for the new offices is lower due to the increased chance of success.
A company’s overall cost of capital is a combination of the returns needed to pay all creditors and stockholders. We often call this the weighted average cost of capital as it takes into account the weighted average costs of your company’s debt and equity.
What’s the Difference Between Cost of Capital & APR?
Many people mistakenly think APR and cost of capital are just two different ways to describe the same thing. However, there are some important differences that could sway you to listen to one over the other.
APR is the annual rate for borrowing a lump sum of money, while the cost of capital is an amount of money — not a percentage.
While it seems logical to assume that a loan with a low cost of capital will also have a low APR, this isn’t always the case. To choose the right loan for your business, you’ll need to consider both APR and cost of capital.
Ask yourself whether you want lower payments or a lower total cost of a loan. If it’s the latter, companies will typically choose the loan with a lower cost of capital.
How to Calculate APR from Monthly Interest Rate
Many lenders use monthly interest rates instead of APR on loans. It can be helpful to make a quick conversion to avoid confusion and draw comparisons with the cost of capital.
Instead of getting bogged down in the nitty-gritty of the calculations, we like to make things simple with an online APR calculator. Simply populate the Google Sheet to make the conversion.
Alternatively, if equations are your kind of thing, this help sheet walks you through each stage of the calculation.
What Is a Good APR for a Credit Card?
If you’re looking for credit cards to cover business expenses, APR is one of the most important factors to consider.
The lower the APR, the less interest you’ll have to pay at the end of each month. Regardless of how strict you are with paying your credit bills, knowing whether you’re getting a good deal will save you money on financed purchases.
Rates for business credit cards tend to start at around 15%, with some card issuers demanding as much as 23% APR.
Credit card APRs tend to change in line with ebbs and flows in national interest rates. Most credit cards will have a variable APR, which means the rate is directly linked or ‘tied’ to a specific interest rate.
In the UK, credit cards are often tied to the London Interbank Offered Rate, or LIBOR. This is an average interest rate calculated by the leading banks in London. Each bank estimates how much it’ll have to pay to borrow money from other banks.
These figures are compiled to find an average rate which credit card providers use to tie APR with LIBOR.
If the LIBOR interest rate rises, so will your credit card APR. However, certain credit card providers change their rates independent of other interest rates. So, it’s important to keep a close eye on your APR to make sure you’re getting a fair deal.
As a general rule, the lower the APR, the better. If you have a healthy credit score, you’ll be more likely to be eligible for a credit card with a low APR.
Be careful not to be distracted by the perks offered by many credit cards. Whether it’s free air miles or cashback on certain purchases, credit cards will often bump the APR and attract customers with fancy perks.
If your ultimate goal is to raise capital, a low APR is usually preferable over the perks.
Watch Out For Compound Interest on Credit Cards
If you’re unable to pay off the full amount on your credit card bills each month, you need to watch out for compound interest.
To calculate your interest payments, you can convert your APR to a daily percentage rate.
Simply divide your APR by the number of days in a year (i.e. 365). Your card provider will multiply your current balance by this daily rate to determine your interest rate.
Crucially, this charge is then added to your balance the very next day, which builds up over time. We call this compound interest.
If you don’t stay on top of your credit card bills, the costs can quickly add up and your credit rating will suffer. A poor credit rating hurts your ability to successfully apply for bank loans or other credit cards in the future.
Overdrafts Can Be Expensive
Overdrafts allow you to access more money than you currently have in your bank account.
Most financial experts recommend only using overdrafts for short-term, day-to-day costs but not as a long-term financing solution.
Depending on your bank’s terms and conditions overdrafts come with a wide range of fees. Typically, going over your overdraft limit will mean you’ll need to pay significant interest on repayments or daily late fees.
Overdrafts are also sometimes secured against business assets, which means you could lose your assets if you’re unable to cover any outstanding overdraft fees in time.
If you’re not careful, overdraft fees can quickly snowball and leave you a sticky position.
As of April 2020, new regulations will come into play which seeks to make overdrafts “simpler, fairer and cheaper.”
The Financial Conduct Authority explains how “consumers cannot meaningfully compare or work out the cost of borrowing as a result of complex and opaque charges.”
The new rules mean banks will no longer be able to charge a premium for unauthorised overdrafts. As it stands, fees associated with unauthorised overdrafts can be up to ten times higher than payday loans.
With the changes looming, you can expect a hike in APRs as banks attempt to absorb hidden overdraft fees.
So, What Factors Affect the Cost of Capital?
Before jumping straight into a funding opportunity, it’s immortality to have your wits about you and understand the true cost of capital.
Here’s a quick checklist to send you on your way:
- The cost of capital is a balancing act between the risk of an investment and the expected returns. The dream is low-risk ventures with sky-high returns.
- Make sure you understand APR when finding the right credit card for you.
- Try to avoid compound interest and maintain a healthy credit rating by paying credit bills on time.
- Don’t become overly reliant on overdrafts. Avoid expensive fees by staying above your lower limit.
Get Your Hands on Cash the Smart Way with LendFlo
Here at LendFlo, we’ve made it our mission to take the pain out of cash flow management with a clear and straightforward approach.
Take advantage of affordable APRs and low cost of capital with Lendflow’s pay as you go service.
The power is in your hands to choose when and how you raise capital with advanced payments on selected invoices.
Learn more about Lendflo today.