Question

3-4 paragraph overview briefly outlining the different methods of funding a business or project. Identify the cost and opportunity cost of each option and how each choice affects the financial performance of an organization.

Answer 1

The business world orbits around capital. Financial activity stimulates economic growth and keeps companies prosperous. However, not all businesses start out with an adequate amount of funding, so business owners need to explore financing options. If fledgling companies do not have proper capital to get their business off the ground, they won't have a high chance of survival against industry competitors. Two major sources are debt and equity.

1.Personal Savings:

This is the most appealing source of financing, because you use your own money to jumpstart your business and don’t owe anyone else in the process.

Pros:

• You have total control of your business, and you may do as you please with your money.
• There’s this satisfaction that you are using your own cash to fund the business.

Cons:

• If the business fails, all the hard work that you had put into your savings will go to waste.

OPPORTUNITY COSTS INVOLVED: Spending today brings immediate benefits or gratification. The opportunity cost is that you will have less money to buy goods and services in the future. Saving builds wealth to buy goods and services such as a car, house, or vacation in the future.

2.Crowdfunding:

This involves funding a business by taking small amounts of capital from a large number of people, usually via the internet. This type of funding makes use of the vast networks you’ve of your friends, family and colleagues via different social platforms to get the word out about the business, with the goal of attracting new investors.

Pros:  Has the potential of expanding a business by getting a pool of investors who can help raise funds.

Cons: Requires time and dedication before results may be realized.

OPPORTUNITY COSTS INVOLVED: monetary opportunity cost, namely the pledge has a monetary value. If you pledge $40 and the campaign succeeds, you immediately pay the $40 but have to wait to get my commensurate reward. You could have used the $40 for any other purchase and actually received a product or service in return. If you would have invested the money or paid of some debt, the opportunity cost is larger than $40 due to the interest you could have accrued or saved.

3.Angel Investors:

Angel investors are wealthy individuals who will provide funding in exchange for a share of equity in the business. Some investors work in groups and screen deals together before providing funds, while most work on their own.

Pros:

• Angel investors can offer valuable advice and guidance since they have experience in the industry you’re in.
• Flexible business terms.

Cons:

• You may be forced to give up control of your business to some extent.

4.Venture Capital:

Venture capitalists are investors who put in a considerable amount of money in exchange for equity in the business, and get returns when the business goes public or is acquired by another company. Venture capitalists are all about the money, and only invest in businesses that have the potential of providing good returns on their investment

Pros:

• Venture capitalists not only provide funding, but can offer expertise and mentorship to help develop the business.
• Venture capital funding gives the business immediate credibility and opens other doors to a wide network of important individuals, such as future investors and partners.

Cons:

• You may be forced to give up a large chunk of your business due to the significant amount of funding provided.

OPPORTUNITY COSTS INVOLVED: Sums paid as returns to venture capitalists may be higher than the interest charges on any other modes.

5.Bank Loans:

Bank loans are a popular source of funding for many startups. Before applying for a bank loan, it’s important to ensure that you are well educated about the various options available, and the interest rates that come with each option.

Pros:

• There are different funding options depending on your needs.
• The funding process is relatively quick if you qualify.
• You don’t have to give up control of your business.

Cons:

• Requires a lot of documentation, which can be tiring and time-consuming.
• You need educate yourself about the best option available for you; otherwise, you might end up choosing a deal that will eventually hurt your business.
• The money has to be paid back whether the business succeeds or not, failing which may lead to loss of your assets, if any.

OPPORTUNITY COSTS INVOLVED: Interest charges which you have to pay for raising loan can be invested to fund capital requirement needs of the business.

6.Credit cards:

Credit cards can provide an effective way to finance a business and to extend your cash flow. You can use them to pay suppliers and often earn discounts, certain protections, or other rewards.

Pros:

• Credit Cards can be very helpful in extending your working capital and alleviating cash flow problems, especially if you use to them to pay suppliers.
• Purchasing power. Credit cards give you purchasing power worldwide — locally and overseas, and online, by phone and at stores, of course. Many credit cards (especially Visas and MasterCards) are accepted virtually anywhere.
• Rewards. By using a credit card, you can earn money back on your day-to-day purchases.

Cons:

• The downside of credit cards is that they are tied directly to your credit score.
• Interest- One of the most obvious drawbacks of using a credit card is paying back interest. You can either pay off purchases in full before the grace period ends and avoid taking on interest, or you can apply for a card with a 0% introductory APR to give you time to pay off purchases without racking up charges.

Cash advances are another source of funds. Most credit card companies impose limits on their cash advances and charge high rates for them. As such, using cash advances can be expensive, but they can also be useful as a last resort

OPPORTUNITY COSTS INVOLVED: Suppose that you choose to spend $100 on a credit card knowing that you'll pay only the minimum when the bill comes due.

CHOICE OF FINANCING OPTION CAN AFFECT THE FINANCIAL PERFORMANCE- EQUIT/DEBT:

Usually the cost of debt is lower than the cost of raising funds through equity. It starts with the fact that equity is riskier than debt. Because a company typically has no legal obligation to pay dividends to common shareholders, those shareholders want a certain rate of return. Debt is much less risky for the investor because the firm is legally obligated to pay it.