Cost of financing and interest rates
Objectives & Goals Click to read
At the end of this module you will be able to:
Financing costClick to read
Capital gains and dividends are required by equity investors, while debt providers seek interest payments.
Financing cost (FC), however, refer to the interest and other fees charged to debt financiers. Interest expense can be incurred on both short-term (less than an year) and long-term financing.
The cost, interest, and other charges associated with an enterprise’s money require to create, purchase assets, or carry out operations – setting up or developing a business – are referred to as financing cost.
Interest and interest rateClick to read
The enterprises and the investors in general use the following formula to calculate financing cost:
In order to better understand the concept of interest and thus financing cost, reference must be made to the interest rate by introducing the concept of time, i.e. the time required to repay the financing.
20% is the interest rate – i.e. the portion of the financing that is charged as interest to an enterprise, expressed as an annual percentage of the outstanding financing.
Compound Interest (CI), also called interest on interest, is another method to calculate financing cost. It is applied to both the capital – principle – and the accumulated interest earned in prior periods.
At the end of the first year the enterprise owes the principle amount's portion plus interest for that year. At the end of the second year, the enterprise owes the principal's portion plus the interest for the that year plus the interest on interest for the previous year. And so on.
So, when compounding, the interest owed is greater than the interest owed when utilizing the simple interest approach. --> CI > SI
For shorter time periods, the interest calculation will be similar for both methods – SI and CI. However, as the financing period lengthens, the discrepancy between the two forms of interest estimates rises, pending in favour of CI versus SI.
Different types of ratesClick to read
APR vs APY
Annual Percentage Rate (APR)
APR is the annual rate of interest without taking into account the compounding of interest within that year.
APR = Periodic Rate x Number of Periods in a Year
Annual Percentage Yield (APY)
APY does take into account the effects of intra-year compounding.
You will be charged the comparable yearly rate of 18% if you just hold a debt on your credit card for one month. However, if you hold that sum for the entire year, your effective interest rate rises to 19,56% due to monthly compounding.
Debt VS Equity financing
OverviewClick to read
The debt-to-equity ratio (D/E) indicates how much of an enterprise’s financing is provided by debt and equity in proportion.
Generally, 0,5 < D/E < 1,5 is considered good in terms of enterprise’s risk.
Debt financing: loans and borrowingClick to read
Tip: Grants are, in essence, gifts. Non-repayable. Grants can be given to individuals, businesses, educational institutions, or no-profits by government departments, trusts, or corporations. There are several parameters to access them.
An enterprise must be incorporated before a loan can be applied for
Equity financing – best practiceClick to read
The scale and scope of equity financing include a wide range of activities, from raising a few hundred dollars from friends and family to raising billions of dollars from huge organizations and a large number of investors in Initial Public Offerings.
Among the most common and well-know kinds outside equity funding are:
Angel Investors: They are someone or groups – generally friends, family or professional investors – who invest their own money in a business. They have no claim on the day-to-day business management.
Venture Capitalists (VC): They are professional and skilled investors who provide capital to selected enterprises. They can invest other people’s money.
Initial Public Offering (IPO): An enterprise can source funds by offering and selling the shares to the public in a new stock issuance. From private ownership to public ownership.
Crowdfunding: The method of funding a project or enterprise by raising money from a large number of people/investors who provide for a small account – as small as €1000 for each investor. It typically starts with an online “campaign” via one of the crowdfunding sites.
OverviewClick to read
What is inflation? Broad increase in prices
Inflation dashboardClick to read