Weighted average cost of management investment portfolio's structure and its optimization
The proposed theoretical model provides a threshold for making decisions about prospective projects: running a project that remunerates entrepreneurs less than the minimum average return is not sensible since the return will not compensate for the risk incurred by the entrepreneurs. Thus, any additional monetary and non-monetary remuneration has to be over and above the suggested minimum average return. The theoretical model has some interesting characteristics and implications.
The first relevant implication of the theoretical model is about the pecking order of financing sources. The model, by adding a category to the possible sources of finance, namely debt collateralized by personal assets, suggests that the pecking order theory as proposed by Myers and Majluf (1984) is too simplistic and not ideally suited to building the Management of an investment portfolio structure of SMEs. Indeed, the theoretical model suggests that equity is not necessarily the most expensive source of finance. This happens simply because the debt collateralized by personal assets has to remunerate both the bank and the entrepreneur. In fact, the additional stake at risk linked to guaranteeing the bank with personal collateral may be very relevant for the entrepreneur. This depends on two elements: firstly the value of firm assets since the lower the value of the firmís assets that can be used to repay the debt collateralized by personal assets, the bigger the additional stake at risk. All other things being equal, in case of an adverse outcome, the entrepreneur will have to use a higher amount of personal wealth to repay the firmís debt if the value of firmís assets is very low and cannot be used to repay the debt collateralized by personal assets. Secondly, the amount of personal wealth is a determining element, since the greater the percentage of personal wealth indirectly invested in the venture via personal collateral, the greater the negative impact the entrepreneur will suffer in the case of an adverse outcome. In fact, the entrepreneur should be compensated for the additional negative impact that their personal wealth might suffer (that is for the additional concentration of their investment). Such compensation is transferred as a higher cost of funding to the venture. Thus, when the value of the firmís assets that can be used to repay debt collateralized by personal assets is very low and the personal wealth invested in the venture is very high, the cost of debt collateralized by personal assets may be higher than the cost of equity invested in the venture.
Secondly, the theoretical model has implications in terms of the financial structure of the venture since it provides a possible additional explanation for the intense use of trade credit by SMEs. Previous research finds that trade credit is widely used by SMEs, since it is easily accessible and is also considered to be a signaling device about the firm, its products and future prospects (Paul and Wilson 2012). Cuñat (2012) stresses that trade credit can be a two or one part contract. In the former case, customers are entitled to receive a discount if they pay immediately; in the latter case, customers do not receive any discount if they pay cash. For the two part contract, the cost of trade credit is defined as the discount received by customers when they pay cash. Previous research provides strong evidence that, in the case of two part contracts, the cost of trade credit is very high (Cuñat 2012; Huyghebaert et al. 2010; Petersen and Rajan 1994). However, irrespective of the cost, firms are said to rely on trade credit because it is the easiest source of finance - definitely easier to obtain than bank finance (Petersen and Rajan 1997). Suppliers are typically more supportive of customers when they need extended credit than banks are (Howorth and Reber 2003) by supplying additional services/goods (Cuñat 2012). Such additional extended trade credit is cost-free since suppliers do not charge extra fees to the customers. In fact, suppliers are in a better position than banks to evaluate the credit quality of customers, they have more tools to enforce proper behavior of customers and therefore have greater control over credit provided (Cuñat 2012). Thus Cuñat (2012) argues that the high price of trade credit incorporates an insurance premium that customers pay in order to be sure of obtaining (non-bank) credit when other sources of finance (typically banks) dry up. However, according to our proposed model, an additional possible explanation can be provided for why firms rely on trade credit when it appears to be so expensive. In fact, in the case of quite small and quite newly established firms where an entrepreneur is required to provide personal collateral in order to obtain credit (that is, the firm does not access uncollateralized credit or accesses only a very small amount of it) and where the stake at risk can be very high since the entrepreneur has invested in the venture the greater part of his/her personal wealth, the cost of debt collateralized by personal assets can be very high. It can easily exceed the cost of trade credit. Thus, in this scenario, it is perfectly rational for entrepreneurs to opt for trade credit rather than bank credit (or to at least switch part of funding to trade credit).
The third relevant implication of the theoretical model is linked to Management of an investment portfolio structure that minimizes the overall cost of Management of an investment portfolio for SMEs. Typically, firms face some problems in implementing an optimal Management of an investment portfolio structure based on their (traditional) calculations, since banks are very conservative in providing debt (and particularly uncollateralized debt). The proposed theoretical model improves the calculation not only by providing a minimum expected return that is specifically worked out for the entrepreneur, but also by considering the peculiarities of a firmís debt collateralized by personal wealth. In summary, the theoretical model is close to what SMEs face on a daily basis: indeed, they have some negotiation power between exchanging equity and debt collateralized by personal assets while they have reduced room for maneuver in the case of uncollateralized debt. Thus, the proposed theoretical model helps SMEs to optimize the mix of equity and debt collateralized by personal assets: it gives them a target Management of an investment portfolio structure that is easier to pursue than the traditional Management of an investment portfolio structure worked out without considering the entrepreneur-specific minimum expected return and the differences in cost between debt collateralized by personal assets and uncollateralized debt.
The last point emphasizes an additional intriguing implication of the model: it is easy to apply. Whoever would like to use it needs just two inputs: the survival rate of the cluster the venture is part of and the history of the entrepreneurís previous success measured simply as the performance of the firm/entrepreneur in previous periods. The former input is in the public domain and can be easily accessed in the local chamber of commerce; the latter input can be easily accessed by entrepreneurs by looking at the historical performance of their venture or previous projects. It is worth noting that all the additional information needed in order to work out the WACC is also accessible and known to the entrepreneur: the amount of personal wealth, the amount of equity, collateralized and uncollateralized debt that will be invested in the project, as well as tax and interest rates charged by the bank. Interestingly, the theoretical model can also be used by banks in order to decide whether it is sensible for the bank to finance the project the entrepreneur is interested in pursuing. In fact, banks too can easily access the survival rate of the cluster a venture belongs to. Moreover, they can quite easily access information regarding previous performance of the entrepreneur, in particular when they have an established relationship with the entrepreneur. It is worth noting that all the additional information needed in order to work out the WACC is also accessible and broadly known to the bank: the amount of personal wealth, the amount of equity, collateralized and uncollateralized debt that will be invested in the project, as well as tax and interest rates charged by the bank. Indeed, this information is available to the bank when it has an established relationship with the entrepreneur.