How can you quickly estimate your cost of borrowing, which is used as the "discount rate," for purposes of analyzing a major purchase decision?
If you are planning to finance the purchase and you know what the interest rate on the loan would be, you can use the rate charged on the loan as the cost of borrowing for the project. Therefore, you would use the loan's rate as the "discount rate" in computing the net present value for the project. (If the rate is variable, you may have to take a guess as to the average rate over the loan period, or do the computation under worst-case and best-case scenarios.)
To fine-tune your calculations, you'll want to account for the fact that interest on business loans is tax-deductible. So, you can multiply the nominal interest rate on the loan by one minus the marginal tax rate for the business, to arrive at the tax-adjusted interest rate.
If you are not financing your purchase, theoretically, you should attempt to compute an average cost of capital for your business that reflects all your current funding sources, including debt and owner's equity. Computing your true cost of capital can be rather time-consuming and complicated, and you'll probably need your accountant's assistance to do it accurately. The calculation depends on a number of economic conditions, opportunity costs, and business risks faced by the company. What's more, using this figure assumes that additional capital can be obtained from similar sources in the same proportion, and at the same rates. For many small businesses, this may not be a realistic assumption.
Instead, you can use your average cost of borrowing as the discount rate. For a very simplified example, the following figures reflect the cost to Clear Corporation of borrowing from each external source that it is currently using. We'll assume that Clear's common stock is currently not paying any dividends.
|Funding Source||Amount||% of Total||Interest Rates||Rate Factor|
|Preferred Stock||$250,000||26%||× 8.00%||= 2.08%|
|Bonds||$250,000||26%||× 8.50%||= 2.08%|
|Loans-Community Devel.||$100,000||10%||× 5.50%||= .55%|
|Revolving Loan||$ 75,000||7%||× 11.00%||= .77%|
|Term Loan||$300,000||31%||× 9.75%||= 3.02%|
In this example, the company's average cost of borrowing would be 8.5
percent. Note that interest rates on all loans must first be adjusted to account
for tax benefits, as described above.