The CFO keeps calling you to bring more IT financial reports down to the conference room. A man you’ve only just met that morning wearing a suit three times as expensive as yours wants to know what you spent on the network last year, and what it’s worth now. And you can’t get your job done for answering questions about the worth of some old 386 computers your people have stored in the warehouse.
If this scene is familiar, in all likelihood your company has survived an audit, probably in conjunction with being merged or acquired by another company. Even more likely, you’re an Internet start-up with auditors crawling all over your books, doing due diligence for your company’s potential investors.
Before they lend your company capital, they want to determine how much your company is worth, what kind of risk they may be taking, and what the potential rewards are. Here’s how to be prepared for them.
Capital for IT ventures typically consists of two components: debt and equity.
The cost of equity
While the CIO doesn't usually think of equity as having a cost, it does. In the most basic of terms, the individual investors in a company have choices as to where they might invest. These alternatives all have different levels of expected return and risk. The higher the perceived risk, the higher the expected return.
An example might be when the management of the company decides to go to the public for the equity. By utilizing this opportunity, management may lower their cost of capital considerably, realizing lower earnings expectations to meet lower costs of capital requirements.
The costs of equity include the interest on the debt, the investors' expected Return On Equity (ROE), and the cost of obtaining the capital itself. Some of the cost of raising capital can be initially folded back into the debt or equity, but at the end of the day it is paid for with additional interest or less profit distribution.
Cost of debt
The cost of debt actually includes several different components. Among the possible components are loan origination fees, broker commissions, points, prepayment penalties (if one prepays later in order to obtain better terms from another source), legal fees (the borrower's and the lender's), appraisal fees, and interest. The component with the greatest impact over time is interest.
The story interest rates can tell
Investors and auditors closely examine interest rates for a number of factors. Many of these factors are quantifiable and can be easily measured. Things such as terms of the loan, interest rates at the time of the loan, and the source of funds are all considered. Also taken into account is whether the loan is fixed or variable. If the loan is one with a variable rate, the basis on which the variable interest rate moves and the range of fluctuation also need to be considered.
On the other end of the scale are more subjective issues. These include the lender’s perception of the company. (If a lender feels secure enough to offer a loan, the company must be solvent, right?) Auditors will add up the value of everything in order to get a handle on the ultimate value of the company’s collateral. Also examined will be the financial stability of the company and its principals. Senior management, including CIOs and other officers, will be scrutinized in an effort to gauge and somehow quantify the quality of the management of the company.
Aside from looking at debt coverage ratios and loan-to-value ratios, the lender or investor is going to consider all of the factors at some level. They will all ultimately affect the amount of the loan and the terms. Every aspect of the terms has a relative cost to the borrower.
For example, you’ve been told the new network migration will have to be put off for another year, yet manufacturing has been given the go-ahead to purchase its new bottling equipment. What gives? A dollar spent on the network is the same dollar spent on the plant floor, right? Well, maybe not. As you know, money spent from current resources is cheaper than borrowed cash.
The cost and availability of capital affects every aspect of competition in your industry in very fundamental ways. In the end, the CIO of a company with less capital cannot afford to make mistakes and has to maximize cash flow by being an excellent manager. The CIO of a company with more capital and higher returns can, of course, afford to pay premium rewards to its key executives and other staff.
For Further Information
The Cost of Capital Center
Venture Planning Associates’ Cost of Capital
- Capital Cost Estimating for the Process Industriesby O.P. Kharbanda and E.A. Stallworthy, Butterworth-Heinemann, February 1989.
- Capital Cost Recovery and Leasingby Earl F. Davis and Caroline D. Strobel, Shepards/McGraw-Hill, June 1987.
- Cost Analysis for Capital Investment Decisionsby Hans J. Lang, Marcel Dekker, May 1989.
- Cost of Capital: Estimation and Applicationsby Shannon P. Pratt, John Wiley & Sons, May 1998.
- Determining Cost of Capital: The Key to Firm Value(with Disk) by Hazel Johnson, Financial Times Management, September 1999.
Jack Fox is Executive Director of The Accounting Guild in Las Vegas. Fox has been assisting thousands of accountants and IT consultants in building their own successful businesses. He has also coached for effective leadership in IT functions of small- to medium-size enterprises since 1984. He is the author of five books, including the third edition of Starting and Building Your Own Accounting Business, published by John Wiley & Sons.Tell us your tips for calculating the cost of capital by posting a comment below or sending us an e-mail.