When it comes to sourcing funds for business, people have the wrong notions as to which source of funds is cheap and which is expensive. Because they've got the cost of funds wrong, they use the wrong fund when it comes to investing in a risky business. This is a slide deck that talks about sources of funds and the cost at which each comes.

1. Myths on cost of capital- BUSTED!
Cost of Capital
Myths:
 Not all sources of funds come at a cost.
 Bank Loans are the most expensive source of funds.
 Reserves / Past profits are free
 For risky projects, use Investor / Promoter funding
I’ve explained the basics of what fund requirement is, what the
sources of funds are, what their costs are and then discussed the
above mentioned myths.
Jaydeep S. Halbe

2. Fund Requirement
No matter what business you are doing, you always require funds.
The quantum of funds required will vary based on business to business
though.
Fund Requirements are broadly for:
 Working Capital Purposes
 Capital Expenditure
Everything you need funds for, can be put in the above two broad
classifications.

3. Working Capital
The difference between what you earn in terms of income and what
you spend in terms of expenditure is called working capital.
You need funds for working capital when what you earn is not
enough for what you spend. The deficit, of working capital required
funds to be infused into the company.
This is a measure of a company’s short term financial health.
For example, if you had monthly sales of Rs 100 and monthly
expenditure of Rs 150, the Rs 50 gap would have to be bridged by
infusing working capital into the company.

4. Capital Expenditure
When you want to buy a fixed asset, it is called capital expenditure.
Fixed Asset is an item that you buy which will give you benefit over an
extended period of time ( greater than one year).
For example: If a business buys a server for Rs. 10,00,000 that server is
going to give the business benefit over an extended period of time.
The server is a fixed asset.
Capital Expenditure can be either for expansion of the business or
replacing old fixed assets with new ones.

5. Sources of Funds
Now that we’ve seen what funds are broadly required for, let’s get
into the sources of funds available to the business:
 Internal Accruals (profits made in the previous years)
 Funding from the Promoter / Founders
 Funding from the bank in the form of loans
 Funding from an External Investor.

6. Internal Accruals/ Reserves
Every year, when a business makes profits, a part of the profits are
distributed to the share holders. This distribution is called dividend.
The remaining un-distributed amount is retained in the business for
further expansion or as a reserve when times are tough.
This reserve that the business has is called internal accruals.

7. Promoter / Founder Funding
The promoter or founder of the business is often the person who
started the business.
When funds are required, if he has the ability and the inclination to put
his money into the business as he considers the business his baby.
Promoter / Founder funding can either be a loan that he gives to the
company or can be for equity.
This decision of loan or equity lies with the promoter / founder and the
company.
In case of loan, the interest rate can be fixed by the Promoter himself.

8. Bank Loan
Banks lend money to businesses for expansion plans as well as
Working Capital purposes. They pay a sum of money to the business
upfront and look to receiving the loan back from the business along
with interest on a regular basis.
The quantum of loan that the bank provides depends on the value
of the project and the amount of money that the business itself is
willing to put in for the project.
A bank will seldom give a loan for 100% of the project value.
Further, the rate of interest depends on the financial strength of the
company & it’s repaying capacity.

9. External Investor Funding
This is the go-to strategy of most start-ups today. Getting funded by
an Investor is highly desirable for start-ups as they believe it gives
them both strategic and commercial advantages.
An Investor values the company and agrees to give a chunk of
money for a share in the equity of the company. He doesn’t charge
an interest on his money.
The investor wants to put in Rs. 100 and take out Rs. 1000 by either
selling the company or getting another round of funding for the
company.

10. Cost of Bank Funds
Now that we’ve listed down the four sources of funds commonly
used in a business, it comes down to cost.
Every single one of these sources has a cost.
Bank Loans are the cheapest form of funds. It’s a myth that the bank
loans are the most expensive source of funds. Even assuming that
your bank loan is at 15%, it’s still the cheapest source of funds.
Why? Because the other sources are way more expensive.

11. Cost of Equity
This is the most expensive source of funds for a company, contrary to
popular belief. Why? Because when someone invests in a company
which is small / startup, the risks are high.
Assuming the investor puts money in a risk free government security,
he’d make 8% as interest. Now if he were to invest in a star-up he
would expect a higher rate of return for the simple reason that he
has taken a substantial risk.
Also the investor’s expectation would be on the higher end as the risk
of investing in a private limited company restricts easy share transfer.
Hence, you’ll realize the return an investor expects is quite high and
hence it’s a costlier source of funds compared to a bank loan.
Equity covers both the investor and the promoter / founder.

12. Cost of Reserves
Another myth is that the reserves of a company is a free source of
funds. People believe that the company has made money and
hence that money is now free.
It’s not. The money which is in the form of reserves belongs to the
shareholders of the company. They have received a lower dividend
from the company so that money can be retained in the business for
expansions.
The investor expects a return on the money that the company has.
He can get 8% by investing money in a risk free government security.
He wants a further return to compensate him for the risk he’s taking.
Hence, these funds too, come at a cost.

13. Conclusion
People often tend to use promoter funds or Investor funds for the
riskiest projects thinking that these funds don’t have to be returned
back to the investor / promoter and hence it’s okay to take a huge
risk with it.
That’s exactly the reason this presentation has been made. Now
you’ll realize that by doing the above, you’re using the costliest
source to do something risky.
Logic dictates that you must use funds which are the cheapest for
the most risky project and keep the costliest source for something
that will give you sure shot returns.
So keep in mind the cost of funds and not just whether the funds
need to be returned or not!

14. If this helped, great!!
If you’ve still got queries,
shoot away!
E-Mail: jay@kenspire.com
Twitter: @jayhalbe