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Theses

1-1-1973

A Cost of Capital and Capital Budgeting Decision Model Related A Cost of Capital and Capital Budgeting Decision Model Related

to New, Small, High Technology Corporations to New, Small, High Technology Corporations

Bruce R. Robinson

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A COST OF CAPITAL AMD CAPITJ^L BUDGETING

DECISION MODEL RELATED TO NEW,

SMALL, HIGH TECHNOLOGY

CORPORATIONS

A Research Paper

Presented To

the Faculty of the Graduate School of Business

Rochester Institute of Technology

In Partial Fulfillment

of the Requirements for the Degree

Master of Business Administration

by

Bruce R. Robinson

January 1973

TABLE OF CONTENTS

CHAPTKR PAGE

I. THE PROBLEM AND DEFINITION OF A NF^f SMALL FIR14 1

The Problem 1

Organization of Paper 2

A Definition of the New Small Firm 2

II. COST OF CAPITAL AND THE NEW PRODUCT INVESTMENT

DECISION WITH RISK 4

The New Product Investment and Risk Analysis

Technique 4

A Comparison to Similar Techniques 11

III. CAPITAL STRUCTURE THEORY 12

Proposed Modified Theory 13

Cost of Debt Theory 22

Cost of Retained Earnings Theory 24

Cost of Equity Theory 2?

IV. COST OF CAPITAL FOR LOCAL SMALL BUSINESSES 31

Description of Research and Analysis '}!

Cost of Eqioity and Retained Earnings for the

Surveyed Firms . 34

Cost of Debt for the Surveyed Firms 44

The Composite Fiiro and a Sample Investment

Opportunity 45

A Sample Investment Opportunity 49

CHAPTER PAGE

V. COMPUTER PROGRAM TO GENERATE IRR VERSUS RISK CURVE .... 51

VI. SUl-MARY OF RESULTS AND CONCLUSIONS 54

Summary of Results 54

Conclusions and Recommendations for Further Study . .58

BIBLIOGRAPHY 59

APPENDIX

A. THE RESEARCH LETTER OF ENQUIRY 61

B. A DESCRIPTION OF RESEARCHED FIRl'iS 63

C. STOCK PRICE CURVES 89

D. COMPUTER PR0GRA14 AND LISTED RESULTS 115

E. CAPITAL PECULIARITIES OF THE NEW SMALL FIRtI 122

CHAPTER I

THE PROBLEM AND DEFINITION

OF A NEW SMALL FIRM

Much has been written relative to capital budgeting techniques

and the cost of capital as separate decisions. In a new small firm

these two decisions become inextricably related.

I. THE PROBLEM

The recent cutback in U.S. Military Defense spending has

freed many engineers and scientist to form their own small businesses

to perpetuate their technological employment. In reviewing their

plight I have foiind these new ventures have developed, or are in

the process of developing, new highly technical products and services

such as data recorders, communications receivers, integrated circuitry,

etc. Many of these products or services are reported to have significant

technical advantages over those currently available. In a few cases the

proposed products are novel enough to be considered capable of filling

entirely new market needs. Also typical of these operations is their

attempt to provide small contract design development services to large

industry and government agencies to provide the capital necessary to

remain in business and support development of the aforementioned

commercial products. The initial capital for these firms consists

primarily of equity contributions of the entrepreneurs, close friends,

family and occasionally SBA backed loans. Many of these firms in the

Rochester metropolitan area are about to survive their first several

years of operation, have completed their new commercial product develop

ment and now must raise capital to introduce these products and initiate

manufacturing. The problem is to raise this capital in a way that will

optimize the firm's capital structure in light of the new product

risks and the component cost of capital.

II. ORGANIZATION OF PAPER

In this paper I have described a simple effective technique for

determining the risk characteristics of the expected return on a

new capital expenditure. I have defined the component costs of capital

and demonstrated how the new venture capital structure can be arranged

to satisfy the risk utility function of the owner entrepreneurs in

light of the expected returns. I have presented preliminary research

which was performed to establish initial estimates of the costs of the

various components of the capital structure. This research was performed

in up-state New York at the time of this study and is applicable to

firms conforming to the definition in Section III of Chapter I. These

estimates were then used in a hypothetical case to demonstrate the

applicability of the study and theory.

III. A DEFINITION OF THE NEW SMALL FIRM

For the purpose of this paper I will limit my definition of a

new small firm to one having the following characteristics :

l) Annual sales of less than $10 million/year

2) Employing less than 250 people

3) Based on new technological product developments or services

4) Incorporated and operating for less than five years

Though somewhat restricted, this definition is applicable to many

new ventures entered into by engineers and scientists and conforms to

the SBA definition of a small business.

CHAPTER II

COST OF CAPITAL AND THE NEW PRODUCT

INVESTMENT DECISION WITH RISK

1

The cost of capital to the firm is the effective rate the firm

must pay to acquire funds for growth and development. It will be

considered as that discount rate with the property that an investment

made above this rate will raise the value of the firm in the eyes of

the owners. Its major application is in deciding whether a proposed

new venture will be profitable. Even though there is considerable

discussion about the means of arriving at this cost of capital and its

component characteristics there is little doubt that such a rate does

exist and coxild be used to evaluate investment alternatives.

I. THE NEW PRODUCT INVESTMENT AND

RISK ANALYSIS TECHNIQUE

The new technologically based firm must convince supporters and

investors that its new ventures would produce returns on their invest

ment and woiJ-d adequately compensate for the investment risk. This

can also be stated as: the firm must assure the investors that the

capital expenditures to be undertaken by the firm woiild have an

expected rate of return at least as high as the cost of capital to the

business. In this sense, the cost of capital would include compensation

M. J. Gordon, The Investment. Financing and Valuation of the

Corporation, p. 218.

Roland I. Robinson, Financing the Dynamic Small Firm. , p. 56.

c

to the investor for risk associated with the new venture. This generally

accepted requirement of the firm may be stated mathematically as:

T^^

C

where: R is the expected value of the rate of

return on the investment considered

R^ is the cost of capital

This rate of return R is generally accepted to be that discount rate

that will permit equating future (after tax) income with present cash

outlays required for the new venture. The component variables

associated with calculating a given rate of return on the new venture

are usually assigned one value and therefore yield one calculated

return. To more thoroughly evaluate a proposed venture a minimum,

average, or maximum value for each component variable can be estimated

and each value assigned likelihood of occurrence. This variable

permits calculating a probability distribution of possible returns on

an investment. To calculate this probability distribution of R for

3the proposed new ventiore one must first estimate the following factors:

David B. Hertz, Risk Analysis in Capital Investment.

Archer and D'Ambrosio, Theory of Business Finance,

p. 400.

Minimum

Qty Likelihood

Average

Qty Likelihood

Maximxmi

Qty Likelihood

Annual Sales

less Variable

Costs and

Estimated taxes

^1 \ ^2 \ *3 "3

Fixed Annual

Operating Costs^1 \ \ \ ''3 "3

Residual Value

of Investment^1 h ^2 \ S h

Useful Life of

Investment\ \ ^2 \ "3 h

Initial Investment \ h \ \ S b

Where: 1) The annual sales less variable costs and estimated taxes (A)

would typically be given by:

ciales revenue -

manufacturing

costs

(labor & materials)

variable

selling

expense

- variable

overhead costs

- variable

facilities

costs

- estimated taxes

2) Fixed Ajmual Operating Costs (B) include the costs for

non-variable items related to plant, personnel and

eqvdpment reqviired to sustain activity on the new venture.

3) Residual Value of Investment (C) is the estimated market

value of all materials acquired for the project with the

initial investment capital. This should include

estimates for depreciation and capital gains tax.

^) Useful Life of Investment (D) is that time period prior

to technical obsolescence of the product or in some

cases market saturation.

5) Initial Investment (E) is that totality of funds required

to initiate and sustain the new venture at its inception.

6) V, W, X, Y, and Z are the related probabilities of

occurrence of each variable A, B, C, D, and E respectively.

To calculate the internal rate of return one equates cost of investment

outlay E vdth the present value of expected future receipts as given

^irA^I-B^*

Cby: E ;

= 5- ^^ ^

j = 1, 2, or 3 minimum, average, or maximum vslue

subscripts

Vi/here: R = Internal rate of returnr

Ej = The cost of investment outlay

A .- B .

= The annual receipts expected from the venture

D .= Useful life of the investment, usually in years

*J

C. = Residual value of investment

This calculation would require selection of one condition (minimum,

average, and maximum) for each of five variables out of three which

would combine to give ,C_ . ,C . -.C . ,C_ .

-,C^= 3 =

243 combinations. Therefore . 243 independent calculations would be

required to obtain the distribution curve of expected returns. I

have concluded this would require the use of a computer to arrive

at the desired distribution in a reasonable amount of time. For each

one of these 243 outcomes I assign the probability (n. = V. . W. . X.

Y. . Z.) associated with each outcome.

3 J

NOTE: It is obvious that the product will go through a product life

cycle as VTith all high technology products. It could be argued that

assiHiiing some constant estimate of each financial variable renders

the analysis less useful. This approach was considered and discarded

because it is somewhat compensated for in the variability attached

to each piece of data and further the shape of the product life cycle

is all but impossible to predict except in the general case.

Each calculated internal rate of return R will then have an

r

associated probability of occurring n. . If one classifies the

internal rates of return into equal return classes and totals the

n. probabilities associated with each return in each class it is

possible to plot a histogram probability distribution or probability

function f(R ) as shown below.*

r

f(Rr)

"lJ

1.^.

Figure #1 Return Probability Function

Summing this distribution from 0 to cjcj one can derive the

distribution function or cr^ulative distribution F(R ) of the discrete

random yariable R^as given by:

FCR,) - ^ f (Rr) fo* 0 -& X & o

?The equal return classes shovild be selected to provide the desired

distribution resolution.

10

This internal rate of return cumulative distribution can be plotted

as a discontinuous function (step function) as shown below.

VCRvlY/' !

PCRy^Rv)

Figure #2 Return Cumulative Probability Function

This ctirve indicates the probability that the actual retiu'n R

on the investment opportunity will be less than any rate of return

chosen on the abscissa (R ). It should be noted that at all pointsr

of discontinunity on this curve the greater of the two probability

values should be used.

11

The new venture can be analyzed in light of the above probability

distributions. The managers could adjust their financial structure

in light of these curves to satisfy the firm's risk utility function,

as ijill be described later.

II. A COMPARISON TO SIMILAR TECHNIQUES

It is worthwhile to note that some scholars in the field of

finance have recommended the decision rule; accept only those invest-

4ments which have a rate of return greater than the cost of capital.

I feel this rule is negligent. It essentially ignores the risk

associated with each projected retiirn. They go on to note that

sometimes the firm should accept investments returning less than

the overall cost of capital if the investment reduces the overall

risk of the firm. This introduces an intuitive risk correction to

the data after many too risky ventures may have been undertaken. The

technique I propose to use mil arrive at the return on investment which

meets with the utility function of the corporation owners. Thus, risk

factors are automatically taken into account in the analysis of each

investment.

Harold J. Bierman, Jr. ,Financial Policy Decisions. p. 81.

^Ibid, p. 81.

12

CHAPTER III

CAPITAL STRUCTURE THEORY

There have been many attempts to establish a theory that can

be used to predict the optimum capital structure. The most revolutionary

approach to the theory of capital structure was set forth by Modigliani

and Miller where they concluded that the cost of capital was a constant,

regardless of the firm's debt-equity structure. Their theory made the

assumption that the stockholder could compensate for corporate debt

risks through modifying his personal portfolio (arbitrage). This

assumption fails since personal leverage is not a perfect substitute

for corporate leverage. Also, they assumed the firm could be classified

in some well defined risk class and neglected taxes. Even after they

corrected for tax effects, their theory maintained that beyond a certain

debt level the required stockholder return would decrease. This runs

contrary to our notion that more risk should entail more return. They

also assvmie that the P/E ratio of stock is unaffected up to some conven-

7taional debt limit which was conveniently left undefined.

The more traditional economic approach to the cost of capital

asstmies that the firm should push its investments to the point where

J. Fred Weston, "A Test of Cost of Capital Propositions",reprinted in Archer and D'Ambrosio, The Theory of Business Finance.

p. 205.

''ibid, p. 204.

13

the marginal return is equal to the marginal cost of capital. The

originators of this concept consider maximizing the return to the

stockholder and maximizing the value of the firm (discounted earnings)

as criterion for establishing the optimal capital structure. Under

conditions of certainty this approach is able to define an optimal

cost of capital and capital structure. However, it proves inadequate

when vmcertainty of cash flow is considered. The proponents of this

technique add risk premiums, super premiums, risk discounts, and more

to their equations to adjust for risk but leave the level of these

adjustments somewhat nebulous.

I. PROPOSED MODIFIED THEORY

For the proposed new small firro capital structure theory, I will

make several assumptions:

1. There is no single long range optimal structure due to the rapidly

changing characteristics of the firm's earnings. Each invest

ment must be considered in light of the current cost of capital.

2. The firm is controlled by one or several individuals who can alter

the capital structure to compensate for changing risk and the

owners'risk utility function.

3. The outside equity capital investor in the small firm is

primarily concerned with growth opportunities as evidenced by

increased value of the firm.

Franco Modigliani and Merton H. Miller, "The Cost of Capital,

Corporation Finance, and the Theory of Investment", Reprinted in:

Archer, and D'Ambrosio, The Theory of Business Finance. p. 126.

14

4. At worse, the small firm can obtain debt financing from SBA backed

sources for one to ten year terms up to l/2 the total capital in the

firm.

5. No debt will be held by equity holders in the firm.

6. Debt limits of the firm's capital structure will be established by

the money market not the capital market.

The proposed modified theory is based on building a capital structure

and selecting investments which yield a return greater than the associated

cost of capital and commensurate with the owners'

risk utility function.

This is accomplished by developing a probability distribution of the rate

of return expected on a new venture and comparing this c\u:"ve with the

various component costs of capital. If the comparison indicates that the

return on an investment is greater than the cost of capital with a likelihood

of loss compatible with theowners'

risk utility function the investment should

be made.

As shown in Figure #3. the owner could theoretically generate a

continuous probability distribution f (R ) of the expected rates of return

on a new venture. The probability that any rate of returnR'

on the new

venture will be less than a selected abscissa value R is given by:

-^r

p(r; < R^) =

( fCR^)(

15

If one substitutes the cost of capital (R ) for the selected abscissa

value, the probability that the new venture will return less than the

cost of capital is similarly given by:

R

P(R; ^ R^) = C"^

f(R^)

I

Since this is equivalent to the probability that the firm will decrease

in value we can state:

Rc

P(decrease in value of firm) = ( f (R )/

It is this probability of a decrease in the value of the firm which must

be less than that which is defined by the owners'risk utility function.

16

Figure #3

H^^)

Probability

Rate of

Return will

be achieved on

Investments

P(R'-<. R ) = P (decrease in value of firm)

R c

Vilhere: Decrease in value of firm is defined as any return

on investments that is less than the controlling

investors expect.

17

gLooking at the weighted average cost of capital as given by:

^c=

\^L^

^dS^Vp

^

^rS.^

^eS

Where: R =weighted average cost of capital

Cy cost of trade credit

C_ =cost of debt capital

Cp= cost of preferred stock

C^= cost of retained earnings

C = cost of external equity

W = ^ of each type of capital in the capital structure

My research indicates retained earnings, equity and debt are the prime

sour<:es of capital. I will consider the characteristics of these costs

individually at a later point in the paper. The cost of capital of the

small firm is now given by:

\=

^dS^Vr^Ve

If we assume that C_ -i C^ < C. The minimum cost of capital is that cost

that first maximizes the use of debt capital (Cj^) consistent with the owners'

desire for safety from defaulting on his debt, then maximizes retained

earnings (Cp) consistent with his growth expectations for the firm. Finally,

equity capital should be used to satisfy the firm's remaining capital needs.

With reference to Figure #4, the owners of the firm would consider using

the expected return on investment curve to determine the risk associated with

s.nY given amount of debt. This amount of debt can be plotted at some value

Wj^C on the abscissa of the expected return curve.

Q

^Eugene F. Brigham, and Keith V. Smith, Cost of Capital

to the Small Firm, p. 175.

Figure #4

^CR,)

18

Probability

Rate of

Return will

be achieved on

Investment

R,r=WoCe Ry - Re

p(r; < w^c^) =

P(default) = Risk =

r^dS

f(R )r

19

The probabilities of potential default on this amount of debt is then given

by the area under the probability c\irve from 0 to W_^C_ or:

Vd

P(default) =

P(R^ < Wj^Cj^) = ( f(R)

This can be explained by analyzing the capital structure again. The first

investors not to be satisfied are the equity investors if we assume solvency

is of prime importance. Since the cost of retained earnings and eqtiity capital

are directly determined by their level of satisfaction in the case where R

goes below R the return to investors through growth or dividends goes to

zero atR' = W_C_ and all earnings go to service debt. The probability

that the debt charges will be covered is not really affected by the amount

of retained earnings or equity investment in the new firm, it is now reduced

to:

P(debt coverage) = 1 - P (R^ ^ W^^Cj^)

This assumed the situation where retained earnings or equity funds are used

to cover debt charges is totally unacceptable.

The amount of debt used is then the maximiam amount consistent with the

ownermanagers'

risk utility function associated with defaulting on loans

or covering loans from other sources. The amount of risk for each level of

debt in the capital structure is then established by the expected rate of

return curve as previously demonstrated.

20

As noted earlier, retained earnings should be used in amoxints consistent

10with the growth objectives of the firm. According to Brigham and Smith

the percentage of equity that must be obtained through external sources

, 11xs given by:

W

\^\

-

G.

G > R

where: W = percent of commonstockholders'

eqiiity in the capital structure

"Wn =percent of retained earnings in the capital structure

G = desired asset growth rate

R - the after tax return projected on existing equity

If R > G the firm is able to generate sufficient funds internally. If

R <. G it becomes more difficult to raise new equity capital. If we assume

that the firm is in its first year of operation, W > 0. Furthermore, to

be consistent with our original assumptions about growth it should be evident

that all retained earnings should be reinvested in the new venture during its

first few years of operation.

To stmimarize, the firm should acquire as much low cost debt as possible

consistent ijith the owners managers'risk utility function as determined

by projected earnings for the following year. All retained earnings should

Brigham and Smith, Og- Git. , p. I87.

-'--'ibid, p. 187,

21

be made available for reinvestment, if growth is the assumed prime objective

of the new venture and additional equity acquired only as necessary to meet

additional investment needs. This iterative approach to optimizing the

capital structure of the new firm should initially yield close to the

minimum practical cost of capital consistent with its growth and risk'

objectives. Ftirthermore,this approach will readily point out which invest

ment alternatives are not consistent with the firm's growth and risk objectives

even at the optimum cost of capital.

22

II ,

COST'

OF DEBT THEORY

If we adhere to the Modigliani and Mller propositions previously

12discarded, we would arrive at a cost of debt given by:

S=

'^t ^^-^c)

where: ^.=

after tax discount rate- applied by the investingpublic to the stock of an unlevered firm in the

same risk class

t = corporate tax rate

C_ =effective cost of debt to the firm

However, there are numerous assumptions associated with this estimate of

the cost of debt that must be noted to vigorously accept and apply this

to our decision model. These assumptions are:

1. The effective cost of debt is that return it must earn in order not

to alter shareholder welfare as indicated by stock price,

2. Some means of measuring the after tax discount rate applied by

investors to the stock of unlevered firms in the same risk class

exists.

3. There is a market for the stock which sets a price toearnings'

ratio and itsinvestors'

exercise arbitrage fully to compensate

for varying corporate debt ratios.

'^'ilbur G. Lewellen, Cost of Capital, p. 44.

23

For new ventures, the stockprice'

is often a highly volatile level deterr.ined

by a rather small market (if a market exists) sample based on the initial

prospectus of the firm or recent earnings'information. There is no well

defined risk class associated with the new firm and therefore there is

little chance of measviring the after tax discount rate applied by investors

to the stock. Therefore it is evident that an application of this cost

technique to the cost of debt is not appropriate for our model.

The more conventional approach to the cost of debt capital is the

after tax, after floatation cost, effective rate the firm must pay for

debt. It is defined explicitly as:

"The rate of return that must be earned on debt-financed

investments in order to keep unchanged the earnings

13available to common

stockholders."

This turns out to be the after tax effective yield on the debt. If we

letD' be the rate of interest on the debt adjusted for acquisition premiums

or discounts and t to equal to the corporate tax rate we have

S= ^' (^ - ^c^

It is this cost of debt, which is compensated for the tax deductability of

interest payments, that will be used as the true cost of debt in the model for

the new venture. This makes no assiomptions pertaining to the effect of debt

on the stockholders or thestockholders'

valuation of the firm's capital.

These factors are considered in the overall model and would be double counted

if considered here also.

13J. Fred Weston, Managerial Finance, p. 341.

24

III. COST OF RETAINED EARNINGS THEORY

Again starting with the Modigliani and Miller approach to the cost of

capital they conclude that the cost of retained earnings is:

"Simply that profit rate which will raise the price of the firm's

stock by enough that after capital gains taxes are deducted, its share

holders are as well off as if they had received a dividend payment instead

14and paid the associated income tax.

"

This compares reasonably well with the conventional argument that:

"The cost of retained earnings, or the return that might be earned

on investments financed by retained earnings is equal to the rate of return

15that investors expect to receive on the

stock."

However, Lewellen, in his expansion of the Modigliani and Miller approach

arrives at the following cost of retained earnings :

R-

(i-y

where: o< +- same as in prior debt formula

**<t

t = personal tax rate of investor

t = capital gains tax of investor

14 /

Lewellen, Cost of Capital, p. 65.

-'j. Fred Weston, Managerial Finance . p. 345.

25

The o<j terra still requires the definition cf a public discount rate

applied to the common stock in an unlevered firm of the same risk class.

Again this is difficult if not impossible to obtain for the new small firm.

(1 - t )However, the ratio ^^^^i"^ ^^^ opportunity ratio of tax

advantages to the investor which is different than more conventional

expressions for retained earnings. Assuming that funds are available

for dividends, if the stockholder takes the dividend he must pay

personal taxes on that dividend at a rate t . If the investor leavesP

funds in the firm in the form of retained earnings he must pay taxes

ultimately on these retained earnings in the form of capital gains on his

sales of stock in the firm. The opportunity cost associated with retained

earnings to the firm would therefore decrease as personal taxes increase

and increase as a function of capital gains tax. This ratio therefore

more accurately describes the opportunity cost associated with retained

earnings than the suggested (1 - t ) factor of Brigham and Smith in the

Cost of Capital for the Small Firm. The Brigham and Smith factor indicates

that as the capital gains tax were increased the cost of capital to the firm

decreases. However this does not logically follow. As the capital gains

tax increased the investor might logically want the firm to give him more

dividends and put a higher premium on having the firm retained earnings.

However, as his personal taxes increase he might put less premium on

receivingdividends and more premium on receiving capital gains as described

by Lewellen 's ratio.

"'Brigham and Smith, Op. Cit. , p. 188.

26

A combined expression for the cost of retained earnings can be

formulated as :

1 - tJ

S=

4 <rr^'

If t > t C^ <C'

p'^

g R^

E

t < t C >C'

p^

g R E

Where :

C' = cost of common equity less flotation cost factors

t = investor tax rate on dividendsP

t = investor capital gains tax

As with the more conventional approach, this cost is defined in terms of

the expected return on common stock and is defined in the next section as

the cost of common stock prior to flotation costs.

27

IV. COST OF EQUITY THEORY

Lewellen interprets the Modigliani and Miller approach to cost of

equity capital as :

^ tC =

E 1 - b

where: C = the cost of equity capital

o< .

= the after tax discount rate applied by the

investing public to the stock of an unlevered

firm in the same risk class

b = discount factor applied due to flotation costs, etc.

Again, as stated previously, o< . is difficult if not impossible to obtain

and carries with it several assimptions not applicable to the new small

firm, as noted previously.

However, some estimate of the rate of return investors expect on

their equity is required. Gordon has most closely approximated this as:

_,dividend

, . , ^u -

^j.

C_, =: + expected growth

-

"5 + gE price

X-

oP

'.iJhere: Cp= the rate of return investors expect on their capital

D = annual dividend payment

P = current price (some say it should be average)

g= expected growth

Lewellen, Op. Cit., p. 72.

^^J. Fred Weston, Op. Cit., p. 40?-

28

Several areas of controversy exist over the use of Gordon's model. First,

he capitalizes an infinite stream of dividends to arrive at this expression.

This assvimes some priori knowledge of the future dividend payments. This

is seldom available. The model also assumes all financing is done with

retained earnings. However, in a new venture dividends are very unlikely

to occur or be expected by the investors for the first few years. This

reduces Gordon's model to:

^E=

^

It therefore remains to be determined what the investors'after tax

expected return through growth will be vxith the new venture and the

cost of eqiiity capital can be written as:

C^ =

E 1 - b

for the new firm. Where 1 - b accounts for flotation costs.

Eqiiity capital in the new firm is acqiiired from both"inside"

investors

and outside investors and each type of capital has its own peculiar cost

characteristics. The inside investor is interested in control of the firm

to assure himself of control over his investment. Another way of looking

at the associated cost of capital is by relating the percent control to the

expected earnings. The cost of such capital may be written as:

C' =

(Projected Earnings^ ^ ownership

E^Insiders' Contribution

^ ^

19Roland Robinson, Financing the Dynamic Small Firm, p. 51 '

29

At first, this may seem to be a myopic view of the insideinvestors'

intentions. However, it can be reduced to our previous cost of equity

expression where we understand that the change in projected earnings based

on the insiders'investment is essentially oxtr definition of growth and the

percent ownership is his share of that growth. In this case, the 1-b

term goes to 1 as b goes to zero since there should be negligible costs

associated with inside investment of funds.

The inside investor can dilute the value of the commonstockholders'

equity in a firm. The initial sale of large portions of the common stock

to inside investors may make future public offerings less attractive.

For example, if the owners of the firm decide to hold 51^ of the firm's

stock for a contribution of ifo of the total equity of the firm the cost of

the capital from this source will be calculated as: For a given return on

total capital these individuals will in essence take l/2 the earnings due

other investors if there were equal distribution of stock per invested

dollar. This is often explained by making inside investors essential

to the success of the new firm and their payment is for this contribution.

This brings out the point that for every growth by a factor of 2 expected

by the outside investor the inside investor may expect a multiple of this

number. Therefore growth in earnings (g) as it is defined in the cost of

equity equation can vary considerably depending on the sophistication of the

investor.

In this sense the growth in earnings required by the inside investor

to realize his desired growth in investment is multiplied by the discount

30

factor by which his stock price was reduced and the commonstockholders'

investment is directly related to the firm's growth in earnings. This is

considered more rigorously in the Appendix E.

In summary we will use the following definitions of the costs of the

various components of capital in the newventures'

capital structure:

Cj= D'(l - t^)

C^ =

'E . 1-b

and the total cost of capital will then be given as:

^C=

^^DD'(l- t^) +

W^ g(-1

t^)+ Wgg

R(. =

Wj^D'(l - t^) + g ( ^R ^rrh

^''e )

Based on this model attempts will be made to calculate typical costs

of capital for the specified type of new small firm.

31

CHAPTER IV

COST OF CAPITAL FOR LOCAL

SMAiL BUSINESSES

The objective of this research is to obtain accurate information on the

cost of capital for new, small, high technology firms. Such information can

then be used to describe a composite firm representative of the firm in this

risk class. This composite firms capital structure can then be used in

conjection with the internal rate of retiirn versus risk computer program to

evaluate the feasibility of new ventures.

I. DESCRIPTION OF RESEARCH AND ANALYSIS

The firms studied were limited to upstate New York to permit close

contact with financial information. This was accomplished by selecting all

local firms from the over-the-counter weekly listing in the Upstate Business

Journal. After initial selection, further research was performed to

insure that the selected firms fit ray previously defined criteria for a

new, small, high technology business. This was accomplished through reviewing

the local business papers from January 1, 1972. Where this information was

not available by such means, calls or visits where made to the firm in

question. In this manner, I foiind 25 out of a possible 73 firms that met

the requirements of this study.

32

Letters were written to the financial officer of each of the 25 firms

requesting their most recent prospectus and latest financial summary. A

sample of this letter is shown in Appendix A. Thirteen positive responses

and one negative response were received in response to the letter. This

was followed by a telephone call or -visit where necessary to clarify the

financial data. These results permitted approximating the cost of capital

and capital structiire for the responding firms.

Realizing that many of the firms to be studied were financed by venture

capital businesses, reviews were made of ciirrent business literature to

locate estimates of the expectations of venture capital firms. The 1971

publication of the Boston College School of Management entitled "Venture

Capital, a Guidebook for New Enterprises"was consulted. It presented ventiire

capital information on 99 venture capital firms. It was written for the New

England Regional Commission yet included venture capital corporations

throughout the North Eastern United States. This source provided quantitative

information on the expectations of 17 venture capital firms. Quantitative

information on RAND Capital Corporation of Buffalo was also located from

local news publications.

Finally, the Upstate Business Joiirnal over-the-counter biweekly listings

were used to plot the stock performance of the 25 firms selected. These

plots were made over a nine month period from January 1972 to October 1972

and used to interpretinvestors'

expectations based on market performance of

stocks in the appropriate risk class. The nine month period was a subjective

limitation imposed by the initial publication of the Upstate Business Journal.

33

The sample mean and standard deviation on all data was calculated

20using:

Sample Mean = X =

^= I

Standard Deviation = S = / a"= I

Where: N = Number of samples

The accuracy of this estimate of the assumed normally distributed

population mean was tested using the"students"

t distribution since

the sample sizes were less than thirty. The confidence limits for the

21population mean are given by:

X + tc (^0

where: t = critical values or confidence coefficients

c

The results for each area of research are presented in the following text

and reduced with analysis oh a functional basis.

20

Murray R. Spiegel, Statistics, p. 70.

^Spiegel. 0. Cit., p. 189.

34

II. COST OF EQUITY AND RETAINED EARNINGS FOR THE SURVEYED FIRMS

As noted in the preceding discussions on the cost ofstockholders'

equity (C^), this cost is directly proportional tostockholders'

expectations.

For the purpose of this study, thesestockholders'

expectations have been

divided into two classifications. The first is the inside venture capital

investor expectations and the second is the over-the-counter secxirities and

new issue investors'expectations.

The venture capital investor usually invests"inside"

money at either

the start of a new venture or at a point when the new firm's products are

developed and ready to manufacture and sell. As noted previously, their

expected return is often higher than"outside"

investors and is reflected in

the total cost of equity by some factor K due to the higher risk factor.

This factor may be arrived at through sale of inside stock at some discount

over the stock publicly offered as shown in Appendix E. However, this

discount decreases the return to"outside"

investors which is eq\iivalent

to increasing"inside" investors'

return. Therefore, the venttire capital

investors'expectations are taken directly at face value as well as the

"outside" investors' expectations based on stock performance. The average

K factor will be based on the average data.

As shown on the following page, information on eighteen venture capital

firms has been acquired. Their exjsected return on invested capital ranges

from 12^ per year to over 100^ peryear. The average of all expectations

is 42^ per year return on invested capital. This result appears to be

representative of the industry based on the small varibility in the data

obtained. However, it is further recognized that this sample size is

indeterminately small compared to the size of the total population.

35

VENTURE CAPITAL FIRMS

SoTirce

1. Albert J. Kelley, Frank B. Campanella,John McKiernan, Vent e Capital

Authors Estimate p.

2. First Connecticut SBIC - p.4l+

3. Bxirgess & Leith - p.66*

4. Creative Resources, Inc. p.68*

5. Explorer Fund, Inc. p.70*

6. Federal Street Capital Corp. p.71*

7. Financial Investors of Boston, Inc. p. 72*

8. Gardner & Preston Moss, Inc. p.76*

9. Kidder, Peabody & Co., Inc. p.81*

10. Koch Venture Capital, Inc. p.82*

11. Paine Venture Fund, p.87*

12. Resoiirces Technology Management Co. p.88*

13. Technology Search Associates, p.89*

14. Baker Technology Associates p.96*

15. Carr Management Company p.100*

16. Diebold Venture Capital p. 108*

17. Neuwirth Financial p.121*

18. Rand Capital Corp. **

Buffalo, New York

Expected Return

25 - 405g/year

12%Iyear

5 times in 5 years

(38^/year)

10 times in inv. period

5-10 times in 5 years

(38^/year)

35 - 50^/year

2 times in 2 years

40 - 50^/year

20 - 30^/year

10 times in 3 - 5 years

(75^/year)

10 times in 5 years

(75^/year)

5 times in 5 years

(38^/year)

40^/year

40^/year

10 times in inv. . period

10 times in 7 years

(405g/year)

5-8 times in 3-5 years

(60^/year)

30^/year

5 times in 5 years

(38^/year)

* From Albert J. Kelley, Frank B. Campanella, John McKiernan,

Venture Capital.

** From Upstate Business Journal. , May 2, 1972, p. 10.

36

Since the sample size for the venture capital data is less than 30, and

if we assume the population very large and normally distributed, the

accuracy of the estimated mean will be evaluated based on the "students"

t distribution with X = 42 and s = 16.27.

Within specified limits of confidence the population mean can be estimated

>,22

by:

42 - y^ I

"^conf. limit '^ 16.27 \/ 15 < ^conf. limit

or z/ lies in the interval:

42 - tconf . limit

At the 55^ confidence level the population mean was calculated as:

41.5^ < yi/ <- k2.5%

At the 95^ confidence level the population mean was calculated to be:

36.4^ < /^ <: 47.6^

This indicates that there is a better than 5^/5^ chance that the mean of the

total population of venture capital firms'annual expected returns on

investments is 42^ + 0.5^. Further, this calculation indicates there is

a 95^ chance that the entire venture capital population expects from

36.4/S to 47.6^ annual return on its investments if the preceding assumptions

hold true.

22

Murray R. Spiegel, Statistics, p. I89.

37

The second stockholder classification for which attempts have been

made to estimate expected gains through stock appreciation are piirchasers

of over-the-counter stocks and new issue investors. In estimating this

factor the following assumptions were made:

1. The growth expectations of this type investor can be reflected in the

current market in which he invests.

2. The local OTC stocks and NASDC listed upstate stocks with a high

technology basis are representative of the stock market for new

high technology ventures. They are in the appropriate risk class.

As evidenced by the research on each of the 25 firms of local interest

all but two were found acceptable for this study. Gould Pumps was found

to have sales well beyond the previously defined limit and Megadyne closed

its doors during the coiirse of the study.

For the 25 firms studied the bid and asked price fluctuations were

plotted over a nine month period from January 1, 1972 as shown in Appendix C.

As noted earlier, my basic premise is that theinvestors'

stock appreciation

expectations on new high technology issues are directly reflected by the

recent performance of stocks in similar risk class. If we assume an

23investor will use only one of three basic strategies:

1. Invest to maximize his maximum gain.

2. Invest to maximize his minimum gain.

3. Invest to minimize his maximim loss.

The later two strategies would tend to force an investor toward the large

exchange stocks which are much less volatile. The first strategy is felt to

be most appropriate for investors in new small high technology firms.

~Z3Kyohei Sasaki, Statistics for Modern Business Decision

Making, p. 213.

38

In general, it is assumed that this type of investor concentrates on

the largest potential gains possible in the appropriate risk class

investment. I have also neglected the trading cost and bid/ask

differentials for this analysis taking the most optimistic view of the

market in line with perceived investor attitudes. A summary of the

stock price fluctuations is shown in the chart on the next page.

39

SUMMARY OF STOCK PRICE CHANGES FROM DECEMBER 31, I97I TO OCTOBER 31, 1972

Average Maximum Maximxm

Change Increase Decrease

AD DATA 0% +2005^ -200^

AQUASONICS-700% +3005^ -13005^

COMPUTER CONSOLES - 18^ + 51^ - 67%

DETECTION SYSTEMS, INC. - 26^ + 20^ - 50%

FERRONICS, INC. - 10^ +1005^ .150^

GOULD PUMPS**0% + 35^ - 31^

GRAHM MANUFACTURING - 30^ + 38^ - 43^

GRAPHIC SCIENCES - 33^ + 35^ - 36^

HAMILTON DIGITAL - 34^ + 50^ - 45^

INFODATA SYSTEMS - 55% + 20^ - 615^

KAYEX - 665^ +160^ - 77^

LASEP. ENERGY 0% +100^ - 50^

MARINE RESOURCES - 66^ + 87^ - 83?^

MEGADYNE* +600^ + 600^ - k6%

MESON + 40^ + 90^ - 47^

METRIX - 78^ +350^ - 90^

PHOTOMETRICS + 485^ +100^ - 40^

R. D. PRODUCTS - 80^ + 16% - 80^

ROCHESTER INSTRUMENT SYSTE14S + 41^ +1005^ - 44^

SCIENTIFIC RADIO, INC. + 25^ + 39^ - 13^

SYKES DATATRONICS + 46^ +133^ - 50^

TAPECON, INC. + 50^ +120^ - 55%

TEL PAGE +100^ +100^ - 50%

TRANSMATION- 505^ + 25^ - 55%

YONDATA- 50^ + 16^ - 50%

** Data not used since firm was found too large for this study.

* Data not used for analysis since firm was out of business by November 1972

41

As noted in the theory, the cost of equity is defined as :

Since many firms floated their own new issue and those that paid

commissions and had noticable flotation costs showed b < 10^, it

will be neglected in light of the large value of g(lOl^). If one

considers the insideinvestors'

expectations of 41^ it is unreasonable

to assume K <! 1. Therefore, at best the results indicate that mean

investors'expectations lie between 41^ (most conservative ) and 101^^

(most optimistic). Both extreme values will be used sequentially in the

composite capital structure.

That is:

C = 41^^1 -

C^= 101^

As noted in the theory, the cost of retained earnings will be defined as;

C

which for this study can be reduced to:

1 - t

Cr=

Cg (Y

^)

V/here: t =investors' tax rate on dividends

P

t = investors'capital gains tax

g

42

With long term capital gains tax, 1/2 that of ordinary income we can

write:

1 - t 1 - t

)

1 - t 1 - t(tr^ ) = (. ^

1 - tg

'1 -

-5t

When this factor is plotted for practical investor tax rates as shown

below it is evident that it is not extremely sensitive to tax rates.

J \

0.-4 -

X

A-

o 80

yvp

43

The average value of the factor is 0.75. Therefore one can reasonably

assume C = 0.75 C in the average case. However, the research indicatesH ill

that few firms had sufficient retained earnings to consider in their

capital structure i.e., W "7^ 0. ^^^ ^rH?~ ^*

44

III. COST OF DEBT FOR THE SURVEYED FIRMS

As noted in the theory on the cost of debt capital, this cost should

be defined as :

V;here:D'

is the rate of interest adjusted for acquisition costs

t is the corporate tax rate.

Of the 25 firms surveyed, sufficient information for calculating the

average interest rate on debt capital was available on 9 firms.

The weighted average value of the interest rate information collected

was found to be 8^ with a standard deviation of 0.88^. Since the sample

size was small (9) the"student"

t distribution was again used to relate

the results to the assumed normal total population. At the 55% confidence

level the actual population mean interest rate could lie between 8.2 and

8.3 percent. At the 95^ confidence level the actual population mean interest

rate could lie between 7-67^ and 8.87^.

This small variation in interest rates is a result of several factors.

First, it was likely that most firms delt with the same banking community

in upstate New York. Second, it was found that many loans were SBA backed

and therefore had a maximum interest rate fixed by the federal government.

Most of the firms had minimal earnings due to heavy investments into

the research and development of new products. Therefore, the minimum tax

rate of 22^ will be used as it is applicable to annual net earnings under

$20,000. The combination of &i% interest rate and 22/S tax rate produces an

average cost of debt capital given by:

45

Cjj= 8i (1 - 0.22) = (,.h%

This cost will be used in the estimate for the cost of debt of the

composite firm.

IV. THE COMPOSITE FIRJ'I AND A SAMPLE INVESTMENT OPPORTUNITY

The cost of capital has been defined as:

S=

Vl-^

Ve^Vr

-^

^D^D

Where: W is the relative weight of each component in the capital structure.

C is the effective cost of that component.

The research surveyed 25 firms to determine the effective cost of the

various components of this capital structure. In summary, this led to

the following estimates :

C^ = hl% to 101^E

\= 0.75 Cg

%= 6.4^

The relative weight of each of these components was also sampled and

is summarized on the following page. The accounts payable portion of

the capital structure was found to average 11^ of the firms total capital.

This, however, was in line with an. average payment period of thirty days to

take full discounts in all but one case. Since this cost of debt is

effectively 0 when the discount is taken, it follows that the (WC) product

for this portion of the capital structure is also zero. The "student" t

distribution was again used to relate these findings to an assumed normal

SUIMARY OF CAPITAL STRUCTURES

46

Accounts Payable Debt Stockholders ' Equity

Firm #1 335^ 20^ 43^

Firm #2 155^ Z5% k9%

Firm #3 M 60%

Firm #4 10^ ZG% 55$

Firm #5 9^ 0 86%

Firm #6 \(>% 58^ 23%

Firm #7 6% 37^ 5k%

Firm #8 5% 28^ 6k%

Firm #9 Q% 0 92%

Firm #10 \Qf% 62% 21^

Firm #11 5% ke% 40^

Firm #12 11^ 57% 26^

Firm #13 4^ 0 72%

Sample Meian 11^ 30^ (40^) 53%

Sample Std. Dev. 7.5i 23^ (14.5^) 225^

55 Conf. Lim.* + 0.3 + 0.8 (+ 0.6) + 0.8

95 Conf. Lim.* + 4.2^ +11,8 (+ 8.8) +11.3^

Number of Firms

in Statistic 12 13 (10) 13

?"Students" t distribution estimate

It should be obvious from the above summary that not all components of the

capital structure are included. The s\m of the three components will

therefore be less than 100^.

47

population. At the 55% confidence level, the population mean would lie at

11^ + 0.3^ and at the 35% confidence level 11^ + 1^.2%. This variation is

still within practical limits for assuming that most firms sampled are

taking full discounts on their accounts payable.

Debt was found to average thirty percent of the capital structure in

the firms analyzed. It was found to average forty percent in those firms

having debt in their capital structure, as shown in parenthesis. The lack

of significant amounts of debt in the capital structure is not too unusual

when one considers that several of the firms analyzed are new and have little

or no revenue on sales. The worse case analysis I will use for the composite

corporation consists of a minimum amount of debt since its effective cost is

much less than the cost ofstockholders'

equity. Further, it is realistically

in line with the high risk firms analyzed to have a minimiam amount of debt.

The variability in the estimate of the population mean was found to be

+0,8^ and +11.8^ for the 55% and 95^ confidence levels respectively. This

wide variability in this estimate is mainly a result of the lack of debt in

23% of the samples. Furthermore, two firms leased their products and there

fore were heavily debt financed. The percentage of debt in the capital

structure will be taken at Wj. = 30^ for the composite firm in light of

the above analysis.

The percentage ofstockholders'

eq\iity in the capital structure of

the firms analyzed was found to be 53'^ with a standard deviation of + 22^.

This large variability in the data is directly a result of the lack of

debt in several finns with excessive debt in others as noted above. Using

48

the "students" t distribution, the uncertainty in estimating the population

mean was determined. At the 551 confidence level the population mean

(assumed normal distribution) could be said to lie between 52.2% and 53.3^

and at the 95^ confidence level between 41.7^ and 64.3^. This estimate is

considered representative of the population in the appropriate risk class

and therefore 53^ is used as the percent equity in the composite firm

(W^= 53^).

In summary, the composite firm could be described as:

Cost of Equity

Percent of Eq\iity

Cost of Retained Earnings

Percent of Retained Earnings

Cost of Debt

Percent of Debt

Cost of Accounts Payable

Percent of Accounts Payable

When applied to our original equationthis yields:

Ct=

w^Cj^-^

WgCg+

W^C^+

Wj^C^

= (0)(11) + (.53)(41 to 101) + (0)(0) + (.30)(6.4)

C^= (21 to 53.5) + 1.9

C^ 55: 23 to 56^

For the composite firm I will use W^^C^= 1.9^ and W^C^

= 21 to 53.5^

s 41% to

^E= 53^^

^R= 0.75 C

\0

% 6.4^

%3056

^L= 0

\ 11^

49

V. A SAMPLE INVESTI4ENT OPPORTUNITY

I have assimilated a sample investment opportunity from my personal

experience to assist in illustrating how the cost of capital and capital

budgeting model may be used. This sample is svimmarized on the next page

in the format outlined in Chapter II. Each variable is based on marketing

product information obtained from a small firm appropriate for the study.

The probability of occurrence of each event was subjectively assigned based

on the experience of several marketing and engineering personnel. There are

many techniques which may be used to develop subjective estimates of the

type used in the sample. It is not the purpose of this paper to limit

the models applicability by limiting it to one technique for assigning

subjective probabilities to the input variables. The technique used may

be suboptimal and its optimization should be the subject of another study.

50

SAMPLE INVESTMENT OPPORTUNITY

Minimum Average Maximum

Qty Likelihood Qty Like! i hood Qty Likelihood

Annual Sales

Less Variable

Costs Plus

Estimated Taxes 25K 0.1 lOOK 0.7 350K 0.2

Fixed Annual

Operating Costs

Residual Value

of Investment

Useful Life of

Investment

Initial Investment

2OK

40K

0.2

0.3

0.1

0.2

50K

lOK

0.6 lOOK 0.2

0.4

0.8

20K 0.3

10 0.1

lOOK 0,75 15OK 0.05

NOTE: K = 1000 multiplier

51

CHAPTER V

COMPUTER PROGRAM TO GENERATE

IRR VERSUS RISK CURVE

The computer program outlined in the flow chart on the following

page, (Figure #5) takes data related to the proposed new venture and

provides data to plot a histogram of the probability of occurrence of

various internal rates of return on a new ventxire.

The program starts by reading the following variables:

A(J) = Annual sales less variable costs and estimated taxes

B(J) = Fixed annual operating costs

C(J) = Residual value of investment

D(J) = Useful life of investment

E(J) = Cost of initial investment

V(J) = Probability of A(j) occurring

W(J) = Probability of B(j) occurring

X(J) = Probability of C(j) occurring

Y(J) = Probability of D(j) occurring

Z(J) = Probability of E(J) occurring

'flhere J = 1, 2, 3 minimum, average, maximum value of each variable

52

Through DO Loops nested five deep all possible combinations of the five

variables are selected along with their associated probabilities of

occurrence. The value of S is set equal to 1 initially and incremented by

1 with each calculation to keep track of the 243 results. The rate of return

RR is initially set to zero and subsequently incremented in steps of 1/2%,

The value of LD is incremented from 1 to the useful life of investment (BD)

and through the associated DO loops, the present value of each year's

revenue is calculated. The residual value of the investment is then brought

forward to its present value and added to the present value of each year's

revenue. This process is repeated in l/2^ increments until the calculated

present value of revenue is greater than or equal to the cost of the

initial investment. The rate of return at this point is stored as RRF(l).

The probability of FFR(l) occurring is then calculated and stored as

P(l). All variables selected for the Ith iteration are then printed out

along with P(l) and RRF(l), I is incremented by one and a new set of

variables are selected. After all 243 possible values of RRF(l) are

calculated with their associated P(l) the program could group the data

into appropriate ranges, I then could total the probability of an occiu-rence

as PX(PRR) whose abscissa ranges are less than each PRR to arrive at data

for plotting the cumulative probability distribution of returns.

s>rART

REAP kc:y)^c::,

,'^.:-:

YCo)-,^CT)

r ^ x+ 1

DO i O 5

BA=A.-.,Tj ,

'r-'{-

/-<-

DO 0:i

JA = 1. 2

EB = Ba A ) EW =W CTA)

-X

^C^ -Xi76y/

D.

j-cM-

/

\

\

'D).:^

N - O

\06

JL"X

t4= 100 7

RR=^R.R-f 0.5

LD = &D

\

DO \03

ELA -EA -h (SA.-SB)/ Cl

&.B=E.A-f CBC/(\+RR)B

PCX) = &V BW 'd-< Bv

H-H4-i

Ev^-

^ rrfcx) ^p:i)

53

I. =X-t-r

X

Do \2.4

VI RR ^\jSO

\

DO 'il-}-

XF

^^i -^ \-

\ IN-

,

y

\ f

PXCMRK;-r-.~} \- r'V V-

1-

^122

1! 12-4J-

DO 127

\kIRR=^U50

.PC

'

''- ;. r-^ I]

127 I

'P< (fN^K ^\)

\ --,

C u Kv'

, \z-^n -JZ

54

CHAPTER VI

SUMMARY OF RESULTS AND CONCLUSIONS

The aforementioned computer program was used with the sample

investment opportunity to define its risk and return characteristics.

These results were then compared to the cost of capital components.

I. SUMMARY OF RESULTS

The computer program internal rate of return and risk data was plotted

as a probability distribution histogram in Figure #6 on the next page.

This curve indicates that there is a 25.5% chance that the internal rate

of retxirn will be less than 0.5^, a 29.5^ chance it will be between 40

and 6Qf% and a 31^ chance it will be greater than 100^^. The data was

grouped in 20% internal rate of return ranges due to the wide range of

possible returns obtained. This wider range of grouping the data also

reduces the likelihood of assuming excessive precision in the estimating

process.

The cumulative probability distribution of returns is shown in Figure

#7- The curve shows the probability that the abscissa value of return

will not be achieved. It also permits easy analysis of the sensitivity

of the venture to varying amounts of the component costs of capital. The

weighted cost of debt and total weighted average cost of capital data

derived from the research are plotted as straight lines from their abscissa

values.

55

n=if"r~rr

-ttl:;

m"--W--

'\\-V-

0

-^:-!T

m

-H-;- xtht_ "-JTJ

:ii

4k

-j-tfh

il

5t rtx:

-TH :;rti

:u*F

XA

-Kf+-

Tttc.

-t4+l-

-^-E

--TX~^

i-;t:v

ch::

lt

E3 -.V:-'-W-

^fl3-;t=

0^.^:

W^

Ei

"prp

0

U|._

fl-H-

St:^

m^

^ff:':t;

32

rH-

r^ii:;

.:i

ttp:J

'S-

! i

44

r.~r

w +m

i"CF

Jj-

T-I7

^T''^;,-

-Ta:^Er^-

44

-4e

-"!-

-I-!-

rT4^4

r

.tr.

I .1 'I:-t

-r rr

m-tir-ririr

T^

20 -^O60 SO lOO

KETURM CRv)

1.0

FI6^7 RErviRN VS R,SK C CUMWuATiv'E.) 5(>

^"Tt

FPt

pprrnr rnr-

i;

ttrr+-

^q

^

m- ffrr +--

tEE^ -=v.

T' 4rt jTirr

"ir i-y^

rrn:

xrn:

PFS

r=z^.

PCCr33maXI^ZEE2

tm

^

;>r^v'

xtth

m

;-H-

Rv)'-

.sU

.41

-,3iKPCr^pS'^'^^

11;

.h-:

IT

/^,

^-'

l-

_\Mj^C^_ ii

iffli

T+X

SD5

nxorrtnr-

^fwS

'r~'

-4ff

V^

N

ij;

-C^

'-..-.1 ; -

- - - r

1 ; j'

L'

1

:- -

i \ :-.t

!

4h

WAX

m -I ; I

-Sf

4f+

--rr-

1-4-1

-

\Z\'l

PT

i:t;

+4;

4:4

4r

ti:ti

hKh

TV-'s::.

"T"

1

II .

-h-r

-i-

^^:

HI20 40 fco ao oo

57

The utility of this approach to optimizing capital structure can now

be readily demonstrated. The weighted cost of debt whose typical value

for the new small firm was found to be 1.9^ is shown graphically as the

vertical line nearest the origin of Figure #6. In line with this proposed

approach, if one decreased the amount of debt financing used for this

venture to near zero, the likelihood of defaulting on payment would be

25.5%. For the typical small firm in this risk class, the likelihood of

defaulting on its debt would be 27.2^. However, of more significance is

the apparent result that an increase in the amount of debt by a factor of

two to 60% of the total capital would produce an insignificant increase

in the likelihood of default. It would also significantly reduce C_, and

therefore significantly reduce the likelihood of stockholder dissatisfaction.

The two plotted total cost of capital lines reflect the variability in

expected equity costs obtained from the research. If one chooses the minimum

return to investors C_ as appropriate, the probability of the firm's

min

success in the eyes of the investors is 70^. If one chooses the maximum

return to investors C_ the probability of the firm's success in the eyes

max

of the investors is reduced to 41.5^. However, the insensitivity of the

returns to varying amounts of debt showed that a factor of two increase

in debt should not increase significantly the risk of default on debt.

Furthermore, this increase in debt would permit reductions in the higher

costing equitycomponents of capital and reduce the overall costs of

capital. For example, theincrease in debt proposed earlier would increase

the probability of the firm's success in the eyes of the stockholders to

70^ from h\.5%. This is because C would be reduced to 28% due to a

max

57^i change in the weight of equity.

58

The above example demonstrates the utility of this approach. However,

it is recognized that any application of this technique must also take into

consideration the attitude of the debt sources and the difficulty associated

with reducing equity holdings in a successful firm of this type.

II. CONCLUSIONS AND RECOMJffiNDATIONS FOR FURTHER STUDY

I have concluded that the proposed technique for evaluating capital

investment alternatives and optimally adjusting the capital structure of

new small firms has demonstrable utility. It permits effective visual

correlation of a proposed new ventxires risk with the way it is financed.

This correlation permits variations in the new firms capital structure to

achieve minimum risk and cost of capital.

Further research should be performed to accurately describe an effective

technique to subjectively assign probabilities to the component characteristics

of a proposed new venture. F\irthermore,correlation coefficients could be

developed for each component of the new venture decision matrix which would

permit a more accurate estimate of the total new venture probability

characteristics. It is also felt that techniques for rapidly modifying

the capital structvire could be developed within obvious practical limitations.

Recognizing that this additional work is essential does not negate the

utility of the proposed analytical tool. This is more evident when one

compares it to the oversimplified techniques now currently employed to

analyze new ventures. This technique should immediately provide a useful

adjunct to the current analytical techniques and provide a more sensitive

financial gioide to new venture investors and entrepreneurs.

59

BIBLIOGRAPHY

Bierman, Harold J. Financial Policy Decisions, London:

The Macmillan Company, 1970.

Brigham, Eugene F. and Smith, Keith V., "Cost of Capital to

the Small Firm", Engineering Economist. Vol 13, #1

Fall 1067, p. 1-26.

Gordon, M. J., The Investment, Financing, and Valuation of

the Corporation. Homewood 111.: R. D. Irwin, 1962.

Hertz, David B. , "Risk Analysis in Capital Investment",The Theory of Business Finance . ed. Stephen H. Archer

and Charles A. D'Ambrosio. New York: The Macmillan

Company, 1971.

Kelley, Albert J. , Campanella, Frank B. , and McKiernan, John,Venture Capital A Guidebook for New Enterprises

.

Chestnut Hill, Mass: Boston College, 1971.

Lewellen, Wilbur G. , The Cost of Capital. Belmont California:

Wadsworth Pub. Co., I969.

Lockwood, Leonard (ed. ) Upstate Business Journal. Volume 2.,

Rochester, New York, 1972.

Loehwing, David A., "Loosening the Purse Strings", New York:

Barron's, April 24, 1972, p. 3.

Modigliani, Franco, and Miller, Merton H. , "The Cost of Capital,

Corporate Finance,and The Theory of

Investment"

,The

Theory of Business Finance, ed. Stephen H. Archer and

Charles A. D'Ambrosio, New York: The Macmillan Company, 1971.

Robinson, Roland I., Financing The D.ynamic Small Firm, Belmont,

California: Wadsworth Publishing Company, I968.

Sasaki, Kyohei, Statistics for Modern Business Decision Making.

Belmont, California: Wadsworth Publishing Company, I968.

Small Business Administration, The Small Manufacture and His

Specialized Staff. Washinton, D.C.: U. S. Government

Printing Office, I967.

Small Business Administration, Publication OPI-I6. Washington, D.C.:

U. S. Government Printing Office, February 1970.

60

Speigel, Murray R. , Statistics, New York: McGraw-Hill Book Co., I96I.

Weston, J. Fred and Brigham, Eugene F. , Managerial Finance, 3r'd ed.

New York: Holt, Rinehart, and V/inston, I969.

Weston, J. Fred, "A Test of Cost of Capital Propositions", The

Theory of Business Finance, ed. Stephen H. Archer and

Charles A. D'Ambrosio. New York: The Macmillan Co., 1971.

Zwick, Jack, A Handbook of Small Business Finance, Washington, D.C:

U. S. Government Printing Office, I965.

61

APPENDIX A

A SAMPLE OF THE LETTER WHICH WAS SENT TO THE RESEARCHED FIRI-IS

4l Penn Lane

Rochester, New York 14625October 18, 1972

Financial Officer

TEL-PAGE CORPORATION

401 Sherman Street

Rochester, New York

Dear Sir:

I am reviewing the characteristics of Rochester

area small businesses as part of my graduate studies

at RIT. I have selected your firm for analysis in

this thesis. I would appreciate a copy of your most

recent prospectus and your latest financial siimmary

to aid in this study.

Yours truly,

B. R. Robinson

63

APPENDIX B

A DESCRIPTION OF RESEARCHED FIRl^S

64

AD DATA SYSTEMS

830 Linden Avenue

Rochester, New York

AD DATA SYSTMS is a nine year old electronics firm specializing

in conversion of information into a form readable by computers. It

employes 125 people with net 1971 sales of $861,133, earnings of

($129,208) on assets totaling $1,230,310. Its performance in sales

and earnings over the last five years has been cyclic with a generally

upward trend.

August 27, 1971 CAPITAL STRUCTURE:

Effective

% of Total Capital Cost/year

Accounts Payable 6% 36% (assumed)

Debt 37% 8,01^

Stockholders'Equity 5k%

Of the 54^ capital representing shareholders'

equity it was found that

the totalstockholders' investment in the firm has been diluted through

losses by 36^. Forty-eight percent of thestockholders'

equity was

obtained in the public offering of I968 and represents only 7.4^ of the

outstanding shares of stock.

Sources of Information:

1. AD DATA SYSTEMS, INC., Prospectus dated May 10, I968.

2. AD DATA SYSTEMS, INC., 1971 Annual Report

65

AQUASONICS, INC.

Aquasonics was started in Rochester and was reported on January 18 -

20, 1972 to be in production of an all-terrain vehicle. It was reported

the firm raised an urgently needed l/2 million and that it was originally

formed to make a jet propelled boat. It had difficulties trying to make

bus shelters and the stock was trading in the l/4 to 3/4 range. No

further information was made available.

Source of Information:

Upstate Business Journal, January 18-20, 1972, p. 1.

66

COMPUTER CONSOLES, INC.

1257 University Avenue

Rochester, New York

Computer Consoles is a four year old firm which sells DATA

MANAGEMENT SYSTEMS. It had 1971 sales of $1,578,683, a net loss

of $879,249 and has assets totaling $2,635,332. Its sales have

increased steadily over the last four years; however, losses have

been sustained consistently.

December 3I, I97I CAPITAL STRUCTURE:

Effective

% of Total Capital Cost/year

Accounts Payable 15.4^

Debt 25.4^ 9^

Stockholders'

Equity 49^

The 49^stockholders'

eqxiity represents only 30^ of the total invest

ment by stockholders. Fvirthermore, 53^ of the total investment by

stockholders was in the form of 8% cumulative preferred stock.

Sources of Information:

1. Computer Consoles, Inc., 1971 Annual Report

2. Computer Consoles, Inc., Applications Reports, 2O5O, 2O5I, and 2052.

3. Computer Consoles, Inc., Interim Reports, June 30, 1972, and

April 1, 1972.

67

DETECTION SYSTEf'iS, INC.

400 Mason Road

Fairport, New York 14450

DETECTION SYSTEMS is a four year old firm engaged in the design,

manufacture and installation of electronic instrusion alarm systems.

It has 1972 total revenue of $818,091 with a net loss of $260,490 based

on the 1972 annual report. However, the July 31, 1972 quarterly report

indicates earnings of $3,990 on sales of $293,125. The firm's total

assets as of March 31, 1972 were $424,020.

March 31, 1972 CAPITAL STRUCTURE:

Effective

% of Total Capital Cost /year

Accounts Payable 33.7$

Debt 20^ 3^

Stockholders'

Equity ^2.7%

The h2.7%stockholders'

equity represents only '^3.5% of the total

investment by stockholders. A public offering with 7.7% potential

discount resulted in an equity contribution of 60^ of total stock

holder investment with only 21.3^ control.

Sources of Information:

1. DETECTION SYSTEMS, INC. 1972 Annual Report.

2. Three Month Report, June 30, 1972, of DETECTION SYSTEMS, INC.

3. DETECTION SYSTEMS, INC., May I5, I969 Prospectus.

68

FERRONICS, INC.

66 North Main Street

Fairport, New York 14450

Ferronics was incorporated in I968 to engage in mamofacturing and

marketing ceramic magnetic materials used primarily in the electronics

and the computer industry. Its current annual rate of sales is $640,000

with a net quarterly income $1,511 for the July - September 1972 quarter.

Total assets as of September 30, I972 were $666,920.

September 30, 1972 CAPITAL STRUCTURE:

Effective

% of Total Capital Cost/year

Accounts Payable 5.25^

Debt 27.8^ 7.2hr%

Stockholders'

Equity 63.8^

The 63.8^stockholders'

equity represents 51^ of the total investment by

stockholders. A July 10, I97O offering of 7.45^ of the outstanding stock

(12.6^ underwriting discount) produced 65^ of the total stockholders'

investment.

Sources of Information:

1. FERRONICS, INC. consolidated Balance Sheet and Income Statement

September 30, 1972.

2. FERRONICS, INC., July 10, 1970 Prospectus.

3. FERRONICS, INC., 1970, 1971 Annual Reports .

69

GOULD PUMPS

Seneca Falls, New York

Gould Pumps are designed and manufactured for use by household

consumers, marine equipment, anti-polluation equipment, and nuclear

power plants. It had 1971 (end of third quarter) earnings of $2,492,925

on sales of $39,292,680. Based on my previous criteria for a small

business, this firm will not be considered further in this analysis

and will be used for background only.

Sources of Information:

Upstate Business Journal, February 1-3, 1972, p. 1.

70

GRAHM MANUFACTURING COMPAIviY, INC.

Batavia, New York 14020

"Grahm man\ifacturers heat exchanges, condensers, steam jet ejectors,

fume scrubbers, relief valves, and related equipment for the petroleum,

petro-chemical, chemical and other processindustries." (From first

source of information below). It had I97I net income of $524,000 on sales

of $11,224,000. It has shown growth in earnings of 42% in the last two

years. The firm has assets as of December 31, 1971 of $7,815,000.

CAPITAL STRUCTURE:

Debt 38%

Stockholders'

Equity 60%

Source of Information:

1. Upstate Business Journal, July 11, I968, p. 18.

71

GRAPHIC SCIENCES

Danbury, Connecticut

Graphic Sciences originated in Rochester, New York to make telephone

transceivers in competition with Xerox. It had 1972 earnings of $658,659

on revenues of 9.8 million. It manufactures devices for transmitting

copies by telephone. No detailed financial information was obtainable.

Sources of Information:

1. Upstate Business Journal: September 5, 1972, p. 1.

July 27, 1972, p. 4.

February 8, 1972, p. 6.

72

HAMILTON DIGITAL CONTROLS, INC.

Utica, New York

Hamilton Digital Controls was a pioneer in high performance shieldless

magnetic recording heads and now sells a shieldless head for cassette

recorders and a low wear version of the same item. It has recently

introduced a vocal recorder which translates computer output into words.

As of August 8, 1972 it had latest fiscal year income of $217,800 on sales

of $1,082,000. It had a current sales backlog of 1 million and will be

expanded into a facility twice as large as it occupied as of August 8, 1972.

No further financial details were available.

Source of Information:

Upstate Business Journal, August 8, 1972, p. 8.

73

INFODATA SYSTEMS, INC.

Rochester, New York

Infodata Systems provides computer services and information

management systems to industry and government. It has received

patents on its Inquire information management system and has at least

one contract which could be worth $500,000 over a three year period.

It also sells a comprehensive time scheduling, accounting, and manage

ment reporting computer management system to radio and television

broadcasting stations. No fiirther information was available on this firm.

Sources of Information:

Upstate Business Journal: July 18, 1972, p. 1

September 5, 1972, p. 8.

74

KAYEX CORPORATION

1000 Milstead

Rochester, New York

Kayex is a local manufacture of electronic semi-conductor devices.

It also has a subsidiary which does special colar imaging and whose sales

represent about 1/4 of gross sales. Its I97I fiscal year sales were 1.1

million down 4.8% from 2.1 million the previous year. This resulted in a

net loss of $931,000 versus $216,654 a year earlier. It reported gross

sales for the first half of this year dropped to $575,845 from $642,665.

This firm openly refused to send me copies of its latest financial report

for obvious reasons.

Sources of Information:

Upstate Business Journal: August 22, 1972, p. 9.

July 30. 1972. p. 7.

April 18, 1972, p. 7.

March 21, 1972, p. 8.

75

LASER ENERGY, INC.

320 North Washington

East Rochester, New York

LASER ENERGY was incorporated January 2, I969 and was to manufacture

and market a low-priced laser and process optical thin film coatings.

It financed its initial operations with $275,000 from inside investors

(700,000 shares @ l<!!/share, 250,000 shares @ $l/share) and raised an

additional $491,574 (200,000 shares @ $3/share), through a public offering

in October I969. The firm showed a net loss of $105,526 on sales of

$154,521 in 1971 and had assets totaling $499,965 as of September 30, 1971.

September 30, I97I CAPITAL STRUCTURE:

Effective

% of Total Capital Cost /year

AccoiJints Payable 8%

Debt 0%

Stockholders'

Equity 92%

The October 28, I969 offering was underwritten at a cost of 15% with

$2.60/share proceeds to the company.

Sources of Information:

1. LASER ENERGY, INC., Prospectus, Dated October 28, I969.

2. LASER ENERGY, INC., 1971 Annual Report.

76

MARINE RESOURCES, INC.

1268 Atlantic Avenue

Rochester, New York

Marine Resources was established in I968 to develop high

technology products for underwater exploration and investigation.

According to F. Robert Hill, the firm has consolidated its local

operations with its Submersible Products Division in Florida. Accordingly,

he did not care to disclose their most recent financial data.

Sources of Information:

Letter from F. Robert Hill, President; dated April 4. 1973.

77

MEGADYNE INDUSTRIES, INC.

Rochester, New York

Megadyne Industries was a manufacturer of microelectronics started

)y two scientists from General Dynamics in I965. It sold 350,000 shares

it $2/share in the 60's and never saw a profitable year of operation.

Controlling interest was purchased in 1970 with the resignation of one

"ounding scientist with 200,000 shares piirchased for $l/share. The firm

ilosed its doors in November reportedly due to financial troubles. No

specific financial information was available.

Source of Information:

Upstate Business Journal: November 28, 1972, p. 1.

78

IffiSON ELECTRONICS COMPAlvlY, INC.

380 Cottage Street

Rochester, New York

Meson makes solid state timing devices and does a large amount of

subcontract electronics work. It had sixmonths'

sales as of December 31, 1972

of $436,828 with earnings of $24,500. This compares to a $13,275 loss a

year earlier. It introduced a new electronic ignition system on August 1, 1972

which is projected to significantly increase future sales. No further

financial information was available at this time.

Sources of Information:

Upstate Business Journal: August 11, 1972, p. 17-

March 13, 1972. p. 1.

February I5, 1972, p. 1 and 3.

79

METRIX DATA SYSTEMS, INC.

1166 Brooks Avenue

Rochester, New York

Metrix manufactures and sells badge identification systems, data

acquisition systems, and a water use recorder. The water use recorder

eliminates meter routemen and its use is now being tested by the Monroe

County Water Authority. It has deferred much of its preoperational and

promotional expenses and showed a net loss of $80,634 for the 1971 fiscal

year. It sold 75,000 shares of stock in 1971 for $6.50 per share. No

further information was available as this firm is still in a start-up

situation.

Source of Information:

Upstate Business Journal, August 18, 1972, p. 4.

80

PHOTOMETRIC DATA SYSTE1'4S CORPORATION

Holt Road

Rochester, New York

Photometric Data Systems manufactures automatic film transports, a

new type of photographic playback system, and a new ultra high speed

microdensitometer. It had 1972 net loss of $126,201 on sales of $523,752

and had assets totaling $819,006.

June 30, 1972 CAPITAL STRUCTURE:

Effective

of Total Capital Cost /year

Accounts Payable 9.6%

Debt 62% 7.7%

Stockholders'

Eqiiity 21%

Of the 21%stockholders'

equity, it represents only 40% of the total

stockholders'

investment.

Sources of Information:

1. Photometric Data Systems Corporation 1972 Annual Report.

2. Photometric Data Systems Corporation, 1972 Presidents News Report.

81

R. D. PRODUCTS, INC.

Victor, New York

R. D.Products'

principle business is the design, development and

distribution of photo-identification systems to banks, retail stores,

commercial credit card companies, schools, industry, and government

agencies. It showed a net loss of $72,290. (Prior to extraordinary

items) on sales of $372,775 for the 6 months ending January 31, 1972.

The firm had assets of $881,669 as of January 31, 1972.

January 31, 1972 CAPITAL STRUCTURE:

Effective

% of Total Capital Cost /year

Accounts Payable 5.1^

Debt 45.6% 7%

Stockholders'

Equity 40%

The 40%stockholders'

equityrepresents only 21% of the total investment

by stockholders.

Source of Information:

R. D. Products, Inc., May 25, 1972 Notice of Annual Meeting

of shareholders.

82

ROCHESTER INSTRUMENT SYSTEMS, INC.

275 North Union Street

Rochester, New York 14605

Rochester Instrument Systems manufactures and services sophisticated

electronic instruments primarily for use by the electric utility and process

control industry. It had 1971 net income of $260,341 on sales of $5,771,261.

It had assets totaling $4,580,592 as of October 1, I97I with a clear

strong record of groxvrth over the last ten years.

October 1, 1971 CAPITAL STRUCTURE:

Effective

% of Total Capital Cost /year

Accounts Payable 10.3^

Debt 25.8% 7.7%

Stockholders'Equity 55%

The 55%stockholders'

equity represents 100% of the totalstockholders'

investment. A 1971 offering (10% discount) of 192,872 shares was fully

subscribed resulting in an equity contribution of 62% of total stockholder

investment with only 27% control.

Sources of Information:

1. Rochester Instrument Systems, Inc., September 7, I97I Prospectus.

2. Rochester Instrument Systems, I97I Annual Report.

y. Rochester Instrument Systems, June 30, 1972, March 30, 1972,

Quarterly Reports.

83

SCIENTIFIC RADIO SYSTEl^IS

401 Lye11 Avenue

Rochester, New York 14606

Scientific RadioSystems'

major product line is high frequency

single sideband communications equipment used as a substitute for phone

communications in underdeveloped countries and by government agencies.

Its current annual rate of sales is $1,480,000 and has just completed its

first profitable period of operation. The firm had total assets of

$481,198 as of June 30, 1971.

June 30, 1971 CAPITAL STRUCTURE:

Effective

% of Total Capital Cost/year

Accounts Payable 9.1^ 36"^ (assumed)

Debt 0%

Stockholders'

Equity 86%

The 86%stockholders'

equity represents only 47.5% of the total

stockholders' investment. A January 27. 1970 public offering (10% discount)

of 100,000 shares at $8.50 per share resulted in an equity contribution of

80% of total stockholder investmentwith only 23% control. This offering

was self-underwrittenand quickly fully subscribed.

Sources of Information:

1. SCIENTIFIC RADIO SYSTE^iS. INC., January 27, 1972 Prospectus.

2. Long Island Investor. June 30, 1971, Volume 3 - Number 5.

3. SCIENTIFIC RADIO SYSTEl^iS, INC., June 30, 1971 Annual Report.

4. Personal interview irith David Hoffman. Vice President, Treasurer,

and Director.

84

SYKES DATATRONICS. INC.

375 Orchard Street

Rochester, New York 14606

Sykes Datatronics'product line is primarily for the minicomputer

market using cassette transport products and datacommunications'

products. Its 1972 sales were $1,636,000 with net income of $46,000.

Total assets as of February 29, 1972 were $1,856,268.

February 29, 1972 CAPITAL STRUCTURE:

Accounts Payable

Debt

Stockholders'

Equity

% of Total Capital

Effective

Cost /year

16% 36% (assimed)

58% 9.1%

23'^

Sources of Information:

1. Sykes, 1972 Annual Report

2. Sykes, August 31, 1972 Six Month Report

85

TAPECON, INC.

475 River Street

Rochester, New York

Tapecon is a specialty converter of electrical and industrial tapes

and metal foils. It has reported earnings of $29,987 for the calendar

year 1972 against losses of $12,907 for the prior year's comparable

period. The shipments during the first half year were $955,207 with a

$233,608 backlog. No further financial information was available on

Tapecon at this time.

Sources of Information:

Upstate Business Journal: August I5, 1972, p. 1.

Kay 2, 1972, p. 7.

May 9, 1972, p. 10.

86

TEL-PAGE CORPORATION

401 Sherman Street

Rochester, New York

Tel-Page is engaged in the sale and rental of mobile telephone and

radio paging services. The firm showed a net income for the year ended

December 31, 1971 of $13,712 on sales of $531,351. It had assets of

$810,366 as of December 31, 1971.

December 31, 1972 CAPITAL STRUCTURE:

Effective

% of Total Capital Cost /year

Accounts Payable 10.8%

Debt 57% 8.95^

Stockholders'

Equity 25.6%

It should be noted that 81% of debt is installment loans on equipnent with

interest rate assumed to be 10%. F\irther, it was evident that the 25.6%

stockholders'

equity represents only 58% of the totalstockholders'

investment.

Sources of Information:

1. Tel-Page Corporation 1971 Annual Report.

2. Tel-Page Corporation July 5, 1972 Proxy Statement.

87

TRANSMATION, INC.

Rochester, New York

Transmation is a local electronics firm which has also operated a

small plastics subsidiary. The Product Packaging Corporation plastics

subsidiary was reported to have orders in excess of $200,000 in February 1972

but was sold in September 1972 for $50,000. Transmation recorded a loss

on the subsidiary sale of $111,000 of which $62,000 was included in its

losses of the first fiscal quarter of 1972. No further financial information

was available on Transmation, Inc.

Sources of Information:

Upstate Business Journal: February 22-24, 1972, p. 9.

September 12, 1972, p. 7-

88

YONDATA CORPORATION

40 St. Paul Boulevard

Rochester, New York

Yondata is principally engaged in the design, assembly and implementation

of special purpose computer systems along with operating a time-shared computer

facility.

April 30, 1972 CAPITAL STRUCTURE:

% of Total Structure

Accounts Payable 4. 1%

Debt 0%

Stockholders'

Equity 72%

Lease agreements have been reflected in the balance sheet at 21.3^ of the

total liabilities . The 72^ stockholders'

equity represents only 5^% of the

initialstockholders'

investment. The firm publicly issued 34.4% of its

outstanding stock @ $l/share June 3, 1969. It was self londerwritten with

no commissions or discounts offered.

Sources of Information:

1. Yondata Corporation, August 22, 1972 Annual Report.

2. Yondata Corporation, June 3, I969 Prospectus.

89

APPENDIX C

STOCK PRICE CURVES

The stock price fluctuation were plotted for a nine month

period as listed in selected issues of Upstate Business Journal.

90

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115

APPENDIX D

COMPUTER PROGRAM AND LISTED RESULTS

The computer printout that follows is an abbreviated version of that

described in the Chapter V flow chart. It takes the matrix for estimated

product profits, costs, and life and the matrix for their respective

probabilities of occurrence and separates the data for all 243 possible

outcomes. It operates on each set of data and prints out the internal rate

of return, probability of occurrence of that rate of return and a reference

number for the data selected.

^16

TYl-29

1.000 C B. R. ROBINSON - A CAPITAL BUDGETING MODEL

2.000 DIMENSION A(3), B(3)> C(3), D(3), E(3)* V(3)* XC3)

2.500 DIMENSION W(3), Y(3)* ZC3), RRF(243)> P(243)

3.000 DIMENSION PX(IOO), CP(IOO)

4.000 11 FORMAT (F10.2)

4.500 13 FORMAT (4F10.5)

5.000 10 READ (5, 11) (A(J), B(J), CCJ)* D(J)* E(jy,

5.200 1 J 1* 3)

5.500 12 READ (5, U) (V(J)^ W(J), X(J), Y(J), Z(J),

5.700 1 J 1* 3)

5.950 I = 1

6.000 DO 105 J s 1^ 3

7.000 BA = A(J)

7.500 BV VCJ)

8.000 DO 105 JA I, 3

9.000 BB s B(JA)

9.500 BV W (JA)

10.000 DO 105 JB = 1* 3

11.000 BC C(JB)

11.500 BX X(JB)

12.000 DO 105 JC = 1* 3

13.000 BO D(JC)

13.500 BY = Y(JC)

14.000 DO 105 JD = 1* 3

15.000 BE = E(JD)

15.500 BZ Z(JD>

16.500 RR = 0

16.700 N 0

17.000 106 CONTINUE

17.200 N = N + 1

17.500 IF (N - 200) 109, 109, 107

13.000 109 RR 3 RR + .5

18.200 EA a 0

18.400 EB = 0

18.500 LD BD

19.000 DO 108 L = l> LD

20.000 EA EA + (BA - BB) / ( I + RR/100)**L

21.000 108 CONTINUE

22.000 EB EA ? (BC / Cl + RR/100)**BD)

23.000 IF ( EB .GE. BE ) GO TO 106

24.000 107 RRF(I) = RR

25.000 P(I) BV * BW * BX * BY * BZ

27.000 WRITE (3, 13) RRF(I)* P(I), I

27.500 1=1+1

28.000 105 CONTINUE

29.000 END

117

BTM SYSTEM-B IS UP

12/26/ '72 11:45

ILOGINt BAl 15348>R0BINSON

ID= U

GOOD DAY,BTM IS UP, PLEASE DELETE ALL OUTDATED FILES, TOM

!ED1T

*EDIT DA7

IN20

20.000 .2

4e

TYl-30

1.000

2.000

3.000

4.000

5.000

6.000

7.000

8.000

9.000

10.000

1 1.000

12.000

13.000

14.000

15.000

16.000

17.000

18.000

19.000

20.000

21.000

22.000

23.000

24.000

25.000

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*END

25000.

20000.

1.

2.

40000.

100000.

50000.

10000.

5.

100000.

350000.

100000.

20000.

10.

150000.

.1

.2

.3

.1

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.7

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.8

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,05

!EDIT

?EDIT INTERNAL

?IN17.5

17.500

? IN20

20.000

IF (N - 200) 109, 109, 107

EA = EA + (BA - BB) / (1 + RR/100)**L

liO

IFORTRAN

OPTIONS* BO

EXTENDED FIV-H VERSION DOO

*? END OF COMPILATION **

(LOAD

ELEMENT FILES:

OPTIONS:

F:5 3 DAT, IN

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122

APPENDIX E

CAPITAL PECULIARITIES OF THE Hm SM.ALL FIRM

The small new firm has several obvious financial peculiarities which

include inside investors, the SBA, and the SBIC. The inside investor is

usually considered part of the entrepreneural group that originates the new

venture. The SBA (Small Business Administration) is a government agency

under the department of commerce which was established explicity to aid

small business. The SBIC (Small Business Investment Companies) are

independent government backed investment companies established to provide

venture capital to small businesses. Along with these, the new small firm

starts with a serious lack of trade credit and is assumed a poor credit risk.

The initial capital for the new firm has been found to come largely from

the original owner entrepreneur. More specifically, about half the money

2used to start small businesses is supplied by the owners. The owners and

members of the original investing group are referred to as inside investors.

This group is often issued stock at a considerable discount from those shares

sold publicly to the non-controlling investors. These entrepreneiu'S expect

some larger return on their investment which can be expressed as by constant

K times the return expected by the outside investor. Also associated with

such inside investors is the lack of flotation costs. Because of these

factors the cost of capital from inside sources can be given by:

^SBA, The Small Manufacturer and His Staff, p. 2?.

^Ibid. p. 27.

123

Inside C =

KgE

If/here K -

multiple due to higher expectations of inside investors

g= growth expectations of outside investor

The overall cost of capital expression should then be written

Cg= Inside

C^+ Outside C

Cp=

Kg +

as ;

1-b

Through interviews with several small businessmen it became evident that these

insiders appear to be rather difficult to locate and prefer to remain in the

background for obvious reasons.

There are distinct advantages for wealthy individuals to invest in

small businesses that fall under the Internal Revenue Code Section 1244 rules.

This code provides an asymetrical tax advantage to the investor.

"An investor in a high income tax bracket stands to retain 75% of his

gains but lose after taxes only 35% of his gross losses if he is in the marginal

tax bracket of 65%.

Though of obvious value to the small firm raising capital, this

asymetrical relationship may perpetuate more problems than it benefits if

the investors decide to write off their losses in the first few years of the

firm's operation.

The Small Business Administration is a federal government agency

established in 1953 by congress to help small businesses grow and prosper.

Eligibility for SBA loans is specified as:

Roland I. Robinson, Financing the Dynamic Small Firm, p. 23.

^Ibid, p. 23.

^SBA Publication OPl-6, February 1970, p. 2.

124

"Most businesses that are independently owned and operated and not

dominant in their fields; that cannot obtain private financing on reasonable

terms and are not eligible for financing from other Government agencies,

and that qualify as "small"under SEA's size standards, which generally are

based on dollar volume of business or number ofemployees."

For a manufacturing firm the above book goes on to note that the firm must

have less than 250 to 1,000 employees to qualify. The SBA will back up to

90^ of a bank loan with bank interest rates limited to 8%. In some cases the

SBA will provide half the loaned capital at a maximum 5^ interest rate with

the commercial bank providing the remaining f\inds. Loans of this type are

limited to $350,000 SBA share mth a maxim-um 10 year maturity for construction

loans and 6 year maturity for working capital. Collateral for these SBA

loans may include:

"Real estate or chattel mortgage; assignment of warehouse receipts for

marketable merchandise; assignment of certain type of contracts, guarantees

or personal endorsements; in some instances assignment of current receivables

Q

and inventories stored in bonded or otherwise acceptablewarehouse."

The SBA through the above program is one of the lowest cost sources of debt

capital to the new small business. Because of the loan guarantee program

and the presumed high risk associated with the new small business it is

apparent that coiTimercial banks would prefer SBA backed loans to conventional

loans. Since their resistance to conventional loans is one criterion for SBA

SBA, "A Handbook of Small Business Finance."'p. 68.

^Ibid, p. 69.

Q

Ibid, p. 69.

125

backed loans it further seems evident that SBA backed loans may be the only

source of debt capital for the new small firm. If we consider the SBA backed

loan as the sole practical source of debt capital which is obtainable at a

maximum 8% rate we would have:*

C^= 0.08 (1 - T^)

The corporate tax (T^) rate for small business depends on their income. If

we ass\OTe that income during the first two years of operation is less than

$25,000 this tax rate would be 22^.

The corporation is taxed at a marginal rate of 48^ on each dollar earned

Q

above $25,000. However, if plowed back earnings are considered -VLtal to the

growth of the new firm and growth is the objective of the owners it seems

reasonable to assume that capital budgeting techniques could be implemented

during the first two years of operation to keep earnings less than $25,000

and the marginal tax rate at 22"^ instead of 48^. This would produce an

assumed cost of debt of:

C^= 0.08 (1 - 0.22) = 6,3^

This should be substantiated in the text of the research.

The Small Business Investment Companies are SBA backed sources of equity

capital for small businesses established by the Small Business Investment Act

of 1958-. These are privately owned and profit motivated corporations

operating under broad SBA guidelines and may invest up to 20^ of their paid-

in-capital plus surplus into any one small business. Currently there are

* Note: Some venture capital is often provided in the form of convertable bonds.

However, the owners expectations will be considered equivalent of that

of equity.

J. Fred Weston, Managerial Finance .

^RA fl Handbook of Small Business Finance, p. 7I.

126

288 SBIC's with 51 boasting equity of $1 million or more and each specializing

in some specific industrial group.

Trade credit for the new small business is often given at extremely

high rates as mentioned earlier. Robert P. H\ingate in Interbusiness Financing:

Economic Implications for Small Business has isolated the factors which determine

trade credit terms and these terms which effect strict or cash terms are:

A. Small quantity purchased

B. Industrial type buyer

C. Weak credit rating

D. Weak competition within the industry

All of these factors are likely to apply to the new, small, high technology,

manufacturing firm considered in this paper and substantiate the initial

assumptions that trade credit will not be used extensively initially.

11David A. Loehning, Barrens

.April 24, 1972, p. 3-