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Chapter 7: Types and Costs of Financial Capital

A new venture must pay its explicit bills (expenses) and its implicit bills (cost of financial
capital). Without adequate capital, even the best ideas and ventures cannot succeed.
Chapter 7 describes financial markets and focuses on how an entrepreneur obtains and
pays for financial capital (debt funds and equity funds). The cost of debt capital is interest
and principal payments and the cost of equity capital is dividends and capital gains.
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). Failure to provide a return for investors will probably result in the lack of
access to capital since investors expect an adequate return.
For mature publicly traded companies with significant track records, financial analysts
review a rich collection of historical data to help produce unbiased and reasonable
projections. However, the financial projections for new private ventures have little or no
historical data on which to base these estimates. Many business plans exhibit venture
hubris, or overconfidence and optimism that ignore the possibility of failure of
underperformance. Therefore, investors examine historical venture capital returns from
the industry using statistical samples and unbiased expected returns.
For this assignment, please answer the following questions (in the text box provided) that
focus on understanding the new terms and concepts from Chapter 7:

Briefly describe the implicit and explicit financial capital costs (i.e.. cost of equity).
[See Section 7.1, p. 233.]

Implicit costs are the costs of using the money for something instead of another item its
the opportunity cost. Explict costs are the expenses or bills.

How do private and public financial markets differ?[See Section 7.3, pp. 233-235.]
The biggest difference is that public markets have stocks. Due to this public
companies can dip into the funds made from stocks for finances while private must
look to other places.

What are the primary providers or sources of early-stage capital? [See p. 235.]

Family, friends, and venture investors.

What is an interest rate? What is default risk?[See p. 235.]


Interest rate is a percentage gained over some time period on money. Default risk is
the chance that someone will not be able to pay back credit.

What is a nominal interest rate? Also, describe a risk-free interest rate and a real
rate of interest. [See page 236.]

Nominal interest rate is the rate quoted on a loan (Nominal = interest rate+ inflation
rate)
Risk free interest rate is the rate of return from interest with no real risks.
Real rate of interest is the interest rate after inflation is factored in.

Define inflation. What is meant by an inflation premium?[See p. 237.]

Inflation is the change in value of the dollar over time. Inflation premium is the part of
interest rates that lenders incorporate to make up for future inflation rates.

Define the term default risk premium.[See p. 238.]


Additional funds a person must pay to lender for default risks.

What is meant by a prime rate? [See p. 239.]


Lowest interest rate available commercially.

What is a bond rating? [See p. 239.]

A rating that indicates a bonds quality.

What is a liquidity risk premium? What is a maturity risk premium?[ See p. 241.]

Its a premium that lendors demand if the item is not easily sold. Maturity risk premium is
a premium based on the length an item takes to mature and the risk of interest changes.

What is meant by the term structure of interest rates? What is a yield curve?[See p.
241.]

Its the relationship between interest rates and maturity times. Yield curve is
another name for it.

Describe the differences between senior debt and subordinated debt. [See p. 243.]
Senior debt is often due to commercial banks and has a lower interest rate.
Subordinated debt is higher risk for the lenders and generally has a higher
interest rate.

Explain the meaning of investment risk of loss and describe how risk can be defined
relative to an average value. [See p. 244.]
Risk of loss is the probability or chance that you will lose your investment. Average
value relates values gained to risk of loss.

Describe the claims on a ventures operating income and any liquidations proceeds in
terms of the debtholders claims and the equity holders claims. (See page 249, para.
4.)
Debtholders claims are more stable and will come before the equity holders claims
because equity holders only get dividends when they companies value appreciates.

What is the difference between private equity investors and publicly traded stock
investors?[See p. 250.]
Private equity is not available for the general public to buy and sell freely like stocks
on the publicly traded stock market.

How does an organized securities exchange differ from an over-the-counter market?


[See p. 250.]
Exchanges are brick and mortar places to trade and buy stocks like the new york stock
exchange. Over the counter markets are more like the online trading sights were dealers
sell the stock too customers.

What is meant by an investment risk premium? What is a market risk premium?[See


p. 251.]
Investment risk premium is the return on investments above the risk free rate of
return.
Market risk premium is the difference between a market account and the risk free
account.

What rates of returns have venture capitalists earned on average in recent years?
How do these returns compare with U.S. public market indices (NASDAQ and S&P
500)?
You should search online for the current venture capital rates of returns which
update the rates in Table 7.2 (page 253) from the textbook.
20% is a mimimum return venture capitalists are looking for compared to the average
of 8% return for the S&P since its inception these are very good returns. But the
returns during the reccesion have not been quite as stellar. This being said i=-09trewq
9876 recent years the returns for both venture capitalists and the S&P are looking
up.

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. [See p. 252.]
Equity capital is estimated by adding together these key components. Inflation, liquidity,
advisory, and hubis projection premiums. You also add the risk free rate.

Describe the relationship between the ventures life cycle stage (development- stage,
startup-stage, survival-stage, and early-growth-stage) the targeted annual returns
expected by investors. [See Figure 7.6, page 255.]
Investors shouldn't expect returns on there investment until at least the early growth
stage before this time expecting returns can cause added strain to an already
struggling company which puts your investment at risk.

What is meant by the weighted average cost of capital or WACC? [See p. 257.]
Its the rate that a company is expected to pay on average to its security holders.