Introduction to Finance

Venture Capital as a Source of Financing for the 
Small Business
Venture capitalists are usually members of partnerships that con-
sist of a few general partners. The typical venture capital part-
nership manages between $50 million and $100 million in assets. 
The general approach for raising investment funds for a venture 
capital fi rm is to set up a “venture capital fund” and seek fi nancial 
commitments from investors to fund the “fund.” It is common to 
organize a venture capital fund as a limited partnership in which 
the venture capitalist is the general partner and the other investors 
are limited investors. The general partner might invest 1 percent of 
the funds and the limited partners the remainder. Investors make 
an initial contribution and commit to provide additional funds up 
to some stated maximum during the fund’s life, which is usually 
ten years. Often an option exists to extend the fund for two or three 
more years. At the end of a fund’s life, cash and securities are 
distributed to the investors.
What are the sources of venture capital? According to 
Ven-
ture Capital Journal
, pension funds provide over one-third of 
annual venture capital funds. Second in importance as suppliers of 
venture capital are foundations and endowments, with 22 percent 
of the funds raised. Endowment contributions come largely from 
university endowments. Investments by insurance fi rms and bank 
portfolios play a major role, as do investments by high net worth 
individuals and families.
Small Business Practice

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18.3 Cost of Capital
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18.3
Cost of Capital
Relevant cash fl ows are incremental after-tax cash fl ows. To be consistent, these cash fl ows 
must be discounted using an incremental after-tax cost of capital. The fi rm’s relevant cost of 
capital is computed from after-tax fi nancing costs. Firms pay preferred and common stock 
dividends out of net income, so these expenses represent after-tax costs to the fi rm. Because 
debt interest is paid from pretax income, the cost of debt requires adjustment to an after-tax 
basis before computing the cost of capital.
A project’s incremental cash fl ows must be discounted at a cost of capital that represents 
the incremental or marginal cost to the fi rm for fi nancing the project; that is, the cost of raising 
one additional dollar of capital. Thus, the cost of debt and equity that determines the cost of 
capital must not come from historical averages or past costs but must come from projections of 
future costs. The fi rm’s analysts must evaluate investors’ expected returns under likely market 
conditions and use these expected returns to compute the fi rm’s marginal future cost of raising 
funds by each method.
Conceptually, investors’ required returns equal the fi rm’s fi nancing costs. The following 
sections use the valuation concepts for bonds and stocks from Chapter 10 to fi nd investors’ 
required returns on bonds, preferred stock, and common stock. We then adjust these required 
returns to refl ect the fi rm’s after-tax cost of fi nancing.
Cost of Debt 
The fi rm’s unadjusted cost of debt fi nancing equals the yield to maturity (YTM) on new debt 
issues, either a long-term bank loan or a bond issue. The YTM represents the cost to the fi rm 
of borrowing funds in the current market environment. The fi rm’s current fi nancing costs 
determine its current cost of capital.
A fi rm can determine its cost of debt by several methods. If the fi rm targets an “A” rating 
(or any other bond rating), a review of the yields to maturity on A-rated bonds in Standard 
& Poor’s Bond Guide can provide an estimate of the fi rm’s current borrowing costs. Several 
additional factors will aff ect the fi rm’s specifi c borrowing costs, including covenants and fea-
tures of the proposed bond issue as well as the number of years until the bond or loan matures, 
or comes due. It is important to examine bonds whose ratings and characteristics resemble 
those the fi rm wants to match.
In addition, the fi rm can solicit the advice of investment bankers on the cost of issuing 
new debt. Or if the fi rm has debt currently trading, it can use public market prices and yields 
to estimate its current cost of debt. The publicly traded bond’s yield to maturity can be found 
using the techniques for determining the internal rate of return on an investment discussed in 
Chapters 9 and 10. Finally, a fi rm can seek long-term debt fi nancing from a bank or a consor-
tium of banks. Preliminary discussions with the bankers will indicate a ballpark interest rate 
the fi rm can expect to pay on its borrowing.
The yield estimate, however derived, is an estimate of the coupon rate on newly issued 
bonds (as bonds are usually issued with prices close to their par value) or the interest rate on a 
loan. Interest is a pretax expense, so the interest estimate should be adjusted to refl ect the tax 
shield provided by debt fi nancing. If the YTM is the pretax interest cost estimate, the after-tax 
estimate is YTM times (1 –