Question

How would you go about estimating the cost of capital for a new, early stage or emerging growth company? What are the similarities and differences in doing so for a mature, established company?

Answer 1

Cost of capital basically means weighted return expected by equity shareholder and debt holder.

Debt holders charge fixed interest and thus whether company is in growth or reached saturation is no relevance to them.

However, equity shareholders expectation of return changes as per the nature of company. If company has already reached maturity it is very clear that growth would be stable and thus not a risky investment for shareholder. Whenever risk is low, return expected will also be low. (High risk high reward & low risk low reward rationale). So, the return (cost of capital) expected by equity holders for matured company would be close to market return i.e S&P 500 index return. On contrast, in case of early stage company return expected by the equity holders would also be high as they are taking high risk. Thus, cost of capital would be S&P 500 market return + Premium factor as company is into early stage.

Overall cost of capital in case of new and matured company would change only because of cost of equity holders. Thus we can conclude that overall cost of capital of early stage company would be higher than matured company.