The Cost Of Capital Is Directly Tied To Risk

In Almost All Cases, Risk and Cost Of Capital Are Closely Related

If you have ever studied the theory of finance (and managed to stay awake through it), you will have been exposed to yield curves, CAPM , risk free rate, weighted average cost of capital, term structure of interest rates, and so on.

Basically, the more risk that’s present in an application of capital, the higher the related cost of capital.

Yet, I continually see business owners that are trying to change the equation while searching for low cost capital with a high associated level of risk.

The lowest interest rates are reserved for opportunities where the lender is well secured, there is well established cash flow, excellent credit, and a reasonable amount of total debt load.

Rates for both debt and equity capital will go up as these investment characteristics become less excellent.

This is pretty straight forward stuff that most people would understand and agree with.

However, the context of society’s basic understanding on the cost of capital is based more on mortgage rates and car loans than anything else.

Business financing can be a whole different ball game due to the higher levels of inherent risk and when we speak of risk, its risk of lender or investor loss.

From a lender or investor point of view, risk has everything to do with the liquidation pathway which stated in different terms means “how do I get my money back if things go south”.

For residential mortgages, the lender puts the house up for sale and gets the funds back in 3 to 6 months, depending on the market and the  foreclosure procedures in play.

For a commercial mortgage, the same applies, but the market can be a lot thinner in terms of buyers, and the time period for sale could turn into years which will require payment of property taxes, maintenance, utilities, etc, which all reduce the proceeds and increase the chance of loss.

Higher risk equals a higher cost of capital.

When you look at unsecured loans based on stated income and credit, the risk is again higher.  For in the event of a failure to pay, what’s the likely hood of the lender getting any money back?

Equity capital is significantly higher than debt capital in most cases due to higher risk of loss by the investor.  Equity investors will demand a wide range of returns, but the range can be as broad as 15% to 30% or even broader … depending on the risk.

Yet I’m still amazed when medium to high risk ventures are convinced they should be able to secure low risk capital.

Unproven business models and business start ups for example are not prime plus type risks.

Many times start ups and unproven ventures get upset with me when I propose relevant business financing solutions that they view to be high or even extortion.   I have had many discussions with entrepreneurs seeking 8% to 12% money for a 18% to 25% risk.  They have nothing to offer in terms of security except the future cash flow projections of their business idea or project.

I then provide the best analogy I have to try and bring them back to earth which is as follows.

A private investor will place second mortgages for 12% to 14%, fully secured by residential properly, providing a higher than normal rate of return due usually to the bad credit of the borrower.  Their relative risk is small, although they will have to be prepared to deal with some foreclosures, but the profit margin is still very good.

So if these guys can get 12% to 14% all day long secured by real estate, why would they ever invest in a venture looking for even a lower rate of interest and not offering any real security except the promise of future profits?

Some times I get through, but most times I don’t.

I guess hope does spring eternal.

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About the Author Brent Finlay