The Cost of Capital in Zambia

Entrepreneurs beware. Capital budgeting is real. You could be starting up a small “nthemba” that sells talk time, setting up a butchery in high density area, investing in heavy equipment that will see you offer a service that many locals only dreamed would be provided by Multinational Corps (MNCs): knowing your cost of capital is real.

The story begins with how to raise capital for that brilliant idea. The options are as follows: Use your salary (Zero interest rate albeit leads to diminished lifestyle in the interim), Borrow from family (0 to 50% interest depending on how large your relative’s appetite for interest is), get a salary advance (0% interest), get an unsecured personal loan (most commercial banks have interest rates north of 30% at the moment) or visit the proverbial loan shark with his moving target interest rate (backed by either title deeds or your car’s white book. These guys are ruthless).

You have the money (most likely from multiple sources) and you invest in the deal. You structure what you believe is a good margin for the product that you are offering. However, overtime it becomes excruciatingly painful to meet all obligations on time (overheads, statutory bills etc). But, you had put a profit margin on your offering that was not only acceptable to the market but promised to catapult your business into the lime light. What on earth happened? How did competitive advantage evaporate? Where did it all go wrong? The answer is knowing the cost of capital of your business. Some will argue that it is an academic exercise. To an extent, it probably is. But in the same vein, how were you so sure that the margins you sort took into consideration that impact of cost on capital? We are told of tails of tenders that are won which promise yields north of 100%, however when we piece together the sources of financing that enabled the facilitation of the deal, we make discoveries of secured financing at high interest rates, agency costs for the facilitation of these deals (believed to be paid for from the proprietor’s pocket but we know where the money is coming from) and problems in the time value of money especially in an era of fluctuating exchange rates.

Cost of capital in its simple form is the price you pay for accessing debt and equity. For debt, issues of interest and tax rates are important. For equity, if you have a pile of cash and would rather not put it in the bank or in treasury bills for belief that a high return is expected if you invest in your company. This is by no means the complete definition but it brings the subject into perspective of some of the elements faced by many companies in Zambia.

Knowing or even having a guesstimate of your cost of capital can help you position your business in an industry that attracts competition. It allows your product to not only give you a return on investment that is positive but also provides you with strategic insight as to whether you are playing the game well in the market or need to exit if value is being destroyed.

We believe that judgment regarding the cost of capital is the quintessential trade-off between business risk and financial risk. On the one hand, firms seek to be in markets they believe yield attractive profits whereas on the other hand the devil is in the detail of their capital budgeting that can either yield success or failure over the long run. The entrepreneur must remember that in its simplest form, financing of business adventures whether through debt (going to financial institutions) or equity (organic financing) attracts a cost that must be of important consideration else the risk failure is very high. We have learnt so far, that premier companies are known to adjust their capital budgeting strategies from time to time. This is the signal that they are aware of the importance of the cost of capital. There is something to be learned there.