Completion of Accounting Chapter Summaries

ACC 201: Essentials of Accounting

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Chapter 10: What is the optimal way to finance your organization?

Where are you going to get the money to finance your initial startup cost?

1. Why do you need financing?

Start-up costs are upfront cost an organization incurs before it starts to generate any cash inflows.

Many good ideas fail to be executed because entrepreneurs find it difficult to finance their start-up costs.

You must initially spend money and register business

Many good ideas fail because of lack of initial money for startup cost.

2. What is the cheapest way to finance your start-up costs?

Finances must be managed

Borrowing to finance the start-up costs is always costly exercise because lenders will want to charge interests.

This is why using your own funds is generally the cheapest way to finance the start-up costs.

If use own funds is there more interest cost?

The reason is that lenders will want to charge a higher interest than the returns our own funds may be making.

Your ‘own’ funds also refers to funds your loved ones (friends and family) are willing to lend you interest free.

What are your loved ones willing to give you? How much do they believe in you?

3. What is the next best way to finance your start-up costs?

You may not have saved enough money to be able to finance all of the start-up costs.

Understand the full cost and how it will effect your life!

Often borrowing from banks turn out to be your next best option as the interest charges may be reasonable.

Nevertheless, the banks may want to check your personal credit rating to qualify you for a loan.

The banks may be willing to lend you at a reasonable rate only up to certain percentage of the start-up costs.

A startup might be too risky for a bank to invest in. The more money you take out, the more of a risk the bank is taking in you.

As the percentage of borrowing gets beyond this level, the banks may want to charge a higher interest rate.

Finally, banks are likely to have an upper limit (a certain percentage of start-up costs) for their loans.

4. When does dipping into credit cards become necessary?

The next place you can turn for more funds is your personal credit card.

The problem with this source of funds is that the credit cards charge a much higher interest rate than a bank.

Moreover, like banks, the credit cards also have an upper limit on the amount you can borrow.

This upper limit often depends on your credit rating .

5. What do you do when you still do not have enough of the start-up costs?

The final place to turn for funding is venture capitalists .

These are investors who are willing to risk their capital on new and risky ventures.

The problem here is that in return for the high risk, they expect a much higher returns.

This return can be in terms of interest charges or company ownership.

Giving up company ownership can minimize your ability to lead your organization the way you like.

6. What is your WACC – Weighted Average Cost of Capital?

Given that the different sources of capital have a different costs, you may want to average them out .

However, a simple average of interest rates is valid only when the amount borrowed is same across the sources.

When different, the interest rate from a source must be weighted by the percentage borrowed from that source.

This is called the weighted average cost of capital or WACC.

Given that interest is a tax deductible expense, the real interest rate is lower than the nominal interest rate.

Accordingly, the weighted average cost of capital is often calculated based on an after-tax investment rates.

7. How do you decide whether to invest in your organization or not?

In essence WACC is the cost of capital , and IRR is the return on investment.

As such, if IRR > WACC then the investment is profitable .

One must, however, be mindful of the risk differences .

Often, the cash inflow from the investment is much riskier than the cash out flow for interest charges.

As such, IRR must be sufficiently higher (IRR >> WACC) for the investment to be profitable.