It’s not enough for your small business to have a good product or service and the demand from a target market. You probably also need funding from investors to carry out the business venture. The cost of funding you pay is the return investors expect to receive. You must decide on the funding sources, equity, and debt, broadly speaking, and their relative proportions within a target capital structure, which affects the overall cost of capital, also known as the weighted-average cost of capital. By adjusting the weight of each form of financing, you can manage your WACC and investors’ return expectations.
When you fund your business using both equity and debt at different levels of costs, you can calculate the average cost of capital by first computing the weight of each type of capital that is, the percentage of each financing source relative to the total amount of capital, and then applying it to the cost of the corresponding capital before summing up the products to arrive at WACC. If you’re considering using the after-tax basis, take the tax deduction on debt interest paid into account. This requires the use of after-tax interest rate as the cost of debt for WACC calculation. The after-tax interest rate is the original interest rate on the debt issued minus the tax benefit from the interest paid, which is the original interest rate multiplied by your business’s income tax rate.
Using equity as a funding source means that you surrender parts of your business ownership to equity investors. This is a way to shift some of the business risk to other equity holders, which is especially relevant for a new small business. When you perceive the risk of your business is high, you want to use more equity for financing; in the event of a business loss, you’re not obligated to pay equity investors their investment returns, neither do you need to worry about paying back their investment capital. However, the downside of using equity financing is that you turn over a bigger chunk of business profits to equity investors in the case of successful operations. Taking a higher risk with their investment capital, equity investors almost always demand a higher return than credit investors, which means a higher cost of equity capital for your business.
If you use debt as a funding source, you are contractually obligated to make interest payments at the stated interest rate and return the principal borrowed at maturity, even if the business is doing poorly, which can put a financial strain on operations. However, this reduces investment risk for debt investors, which is why they often accept a lower return on providing debt financing, allowing a lower cost of debt capital for you. With debt being a cheaper funding source, your business gets to retain all the after-interest profits without having to share anything beyond what the interest rate calls for. Using debt is a financially sound decision when you expect your business can do relatively well and has the ability to fulfill debt payment obligations. You have to monitor the costs associated with issuing equity and debt based on changing business conditions. The relative amounts of equity and debt your business uses determine the WACC, and the goal is to take advantage of both the safer equity and cheaper debt and achieve an optimal WACC.