Running Head: SMALL AND MEDIUM SIZED ENTERPRISES (SMES), AND THEIR COST OF CAPITAL

Existing finance literature is inadequate with respect to its coverage of the capital structure of small and medium sized enterprises (SMEs). This lack of coverage means that SMEs are provided with little or no guidance for optimising their cost of capital. This paper is an attempt to provide such guidance. For unlisted SMEs the cost of equity cannot be derived from the capital market, nor can it be ascertained by asking the entrepreneurs, since their decision to invest is usually driven by many other factors, over and above the simple (financial) return on investment requirement. A further problem in quantifying cost of equity results from the fact that entrepreneurs can be asked to provide additional (informal) investment in the form of personal guarantees. We put forward a model that attempts to solve these problems. Firstly, our model determines a “legitimate” expected return for the entrepreneur, by considering the probability of liquidation of the venture and the loss incurred by the entrepreneur in this event. The former can be derived by looking at the specific survival rate of firms; the latter, is based on how much the potential bankruptcy affects the wealth of the entrepreneur. Secondly, we suggest taking into consideration the personal collateral provided by the entrepreneur, as if it were additional equity invested in the venture. To calculate such an amount, we suggest taking into account only the amount of collateralised debt that cannot be covered by the revenue from the sales of the firm’s assets in case of liquidation.