company valuation and investment - optimizing the cost of capital
Capital is necessary to buy the assets required to obtain future Cash Flows. The objective is to raise capital at the lowest possible cost of capital. The cost of capital under any circumstances always means the economic cost attract investors or lenders in a competitive environment where they are carefully analyzing and comparing investment opportunities. The cost of capital can be thought of as an opportunity cost, that is, the cost of foregoing the next best alternative investments of similar risk. The cost of capital is market driven, comparable to other investment of similar risk.
The managers needs to raise capital at the lowest possible cost, because the cost of capital is actually the amount of company ownership that needed to be sold for raising capital.
For example, the amount of cash needed is $650,000. If the company is valued at $1,000,000, the investor would expect 65% ownership of the company to make the investment. That is calculated by using the formula below:
%Ownership = Cash needed / Company Value
At a valuation of $1,500,000, the investor would expect 43.33 percent ownership of the company. At a valuation of $2,000,000, the investor would expect 32.5 percent ownership of the company.
So, the higher the company valuation, the lower the cost of the investment to the business owner, and less of the company will be given away.
Reference:
Sawyer. T. Y. (2009). Pro Excel Financial Modeling: Building Models for Technology Startups. Apress.
