Balance sheet and investment choices-Using External Debt as Source of Capital

Scenario : Using External Debt as Source of Capital

If an entrepreneur was externally financed through loan borrowing from a financial institution such as a bank, then he/she need to consider opportunity cost of the borrowed amount.

Steps of choosing the right investment

Step One: Identify a variety of Business Opportunities

Carry out an investment market survey to identify different business opportunities with returns more than the cost of borrowing (ie debt interest rate).

Step Two: Select the most competitive investment opportunity

The best alternative selected will be pegged on the returns to be derived from the investment opportunity selected and the cost of borrowing.

Step Three: Select the most suitable Investment

The most suitable investment is the one whose returns are equal or more than the cost of borrowing

 

Illustration

Wellington is a new investor in the market and has borrowed a loan of $120,000 with 10% interest rate. He has identified the following business opportunities

Opportunity one-12% per annum

Opportunity two-7% per annum

Opportunity three-16% per annum

Opportunity four-22% per annum

NB: All the investment opportunities had the same initial capital outlay of $120,000

Required analyze the best investment Wellington should select or invest in

 

Solution

Step one;

The available opportunities are

Opportunity one-12% per annum

Opportunity two-7% per annum

Opportunity three-16% per annum

Opportunity four-22% per annum

 

Step two;

The most suitable investment is that with 22% return for it is higher than the cost of borrowing

The balance sheet representing this selection will be as follows;

Balance sheet format

Therefore, the selected investment returns (benefits) exceed the cost of borrowing by 12% (22-10). Hence it is profitable