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Why Every Small Business Owner Needs to Understand the Cost of Capital

Management

Why Every Small Business Owner Needs to Understand the Cost of Capital

Updated: Feb 5, 2020

Why Every Small Business Owner Needs to Understand the Cost of Capital

They say it takes money to make money.

Whether it’s through bootstrapping, raising equity, or lending, an upfront investment is often needed to get a business project going.

With 99.95% of small business owners using loans to fuel the growth of their businesses, debt financing is the preferred way for entrepreneurs to secure capital.

However, forgetting to put an annual percentage rate (APR) into the right context can make some business owners miss out on taking on financially sound loans.

Let’s review how to think about the cost of debt, or the cost of borrowing capital for business projects.

What is the Cost of Capital?

An interest rate is the amount that a lender charges for the use of capital.

When you’re considering business loans, the APR is the right benchmark to measure the cost of that type of capital.

The main reason is that APR is the annualized cost of a loan, including all interest payments, fees, and services charges.

Here’s how the APR allows you to make an apples-to-apples comparison of different forms of debt financing. Let’s consider two options:

  • A $70,000 term loan payable in 36 months with a fixed interest rate of 12% and an origination fee of 3%
  • A $70,000 merchant cash advance (MCA) with a payback amount of $85,000, a 15% charge on projected monthly card sales of $70,000, and an origination fee of 3%

The estimated APRs of the term loan and the cash merchant advance are 14.13% and 69.04%, respectively.

In this example, these two numbers make it clear that the MCA has a higher capital cost than that of the term loan.

When calculating the APR, some business owners may become concerned that this rate appears too high. But a higher interest rate doesn’t always mean it’s the wrong decision, given that you understand the cost of capital and how your business will generate additional funds with the loan.

Let’s take a look at this through a case study.

Cost of Capital Case Study: Annie’s Flower Shop

Annie started a flower arrangement business from her garage and has consistently secured more orders year-after-year for three years.

Business is growing so much that she is turning down big orders too often due to her lack of space. She really needs to bring her flower shop out of the garage and into a more suitable location with larger storage arrangements and better ways to preserve her inventory.

After crunching the numbers, she believes that $55,000 should cover the rent for the first year at a nearby warehouse and purchase the necessary equipment.

When she shops around for debt financing, she finds a $55,000 term loan payable in 24 months with a fixed interest rate of 15% and an origination fee of 3%.

Using the Bond Street Calculator, she finds out that this term loan has an APR of 18.13%. Annie is caught by surprise by the high APR, it’s even higher than that of her credit union’s credit card!

But then, Annie decides to make some additional calculations.

From the Bond Street Calculator, she also finds out that her estimated monthly payment is $2,666.67.

She knows that by moving to the new space and leveraging the new equipment she could add an extra $6,000 to her current monthly revenue of $16,700.

Taking on the new debt, would not only cover her monthly payment but also leave her an extra $3,333.33 in revenue.

Taking on the term loan would not only allow her to cover her debt payments but also open the door to many opportunities, such as building cash reserves, hiring an additional part-time or seasonal employee, or purchasing additional equipment. If anything, she could even pay back the loan faster than in 2 years and save on interest charges!

In summary, it makes financial sense to take on a loan with an APR up to the point that your additional revenues will cover the new debt payments.

Once the debt is paid off, your revenue after debt will be higher than it was before the loan.

Debt doesn’t always have to be scary. It’s actually the tool that is used most by entrepreneurs to unlock growth. If you understand your business and the cost of capital, debt is very manageable and really an asset.

Cost of Borrowing FAQ’s

Do all lenders give me an APR?
Yes, because federal law requires them to do so.

The Truth in Lending Act (TILA) of 1968 states that a lender must present a loan’s APR, term, and total costs to the borrower in writing before signing, and also possibly on periodic billing statements.

TILA requires lenders to disclose their schedule of fees but doesn’t set parameters on what they should be.

Keep in mind that all of this info might be in the fine print, so make sure to check them before putting your name on the dotted line.

Is there anything I should watch out for when calculating the APR?
The most important detail is how the interest rate of your loan is determined.

A loan may have a fixed interest rate or a variable interest rate. The first type of rate doesn’t fluctuate over time, but variable rates are tied to a benchmark, such as the federal funds rate or prime rate.

When the benchmark is adjusted upward, the variable rate also rises. Conversely, when the benchmark goes down, so does the variable rate.

In the earlier example of the $70,000 term loan payable in 36 months with a fixed interest rate of 12% and an origination fee of 3%, we found that the loan had a 14.13% APR. Assuming that this loan had a variable rate and that rate was adjusted to 13%, the new APR would be 15.14%.

If you opt for a variable interest rate, your APR may change so it’s important to calculate what’s an acceptable range for you.

Make sure to find out the monthly payments under a couple scenarios to determine whether or not a loan with a variable rate would make sense for your unique financial situation.

Review the terms of the loan carefully to understand what events would trigger changes in your APR.

Generally, a loan with a variable interest rate can be beneficial to established businesses that can pay off the loan relatively quickly. This means a business with a steady stream of cash inflows that won’t be affected by a hike in monthly debt payments.

Should I just go for the first loan I find as long as it has an acceptable APR?
No, you should always consider all loan options to which your business could qualify for.

For example, if you already submitted an application for a business loan to a bank or the Small Business Administration, you could also get prequalified for a term loan with Bond Street.

Unlike other lenders, Bond Street doesn’t charge you origination fees unless you accept the loan offer and doesn’t do a “hard inquiry” on your credit report.

Different lenders have different processing times. Generally, banks and the SBA take several weeks to review your application and then a few more to fund your account.

On the other hand, Bond Street provides an offer within 72 hours. When projects have a short window of opportunity, getting pre-qualified with Bond Street could help you to be ready faster.

To help you get ready for your loan application, here’s a step-by-step guide to applying for a Bond Street term loan.

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