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.
About the Author - Dr Geoffrey Mbuva(PhD-Finance) is a lecturer of Finance and Accountancy at Kenyatta University, Kenya. He is an enthusiast of teaching and making accounting & research tutorials for his readers.