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2.2 Understand Conventional and Risk FinancingInvestors consider different types of risk when choosing how to invest. Check out these descriptions of three basic types of investment risk. You have two basic external funding sources: conventional capital and risk capital. Each option bears a different cost. And risk is the key to determining what the cost will be to finance your growing business. Conventional sources lend at lower rates but impose restrictions to lower the lender's risk. So, for example, when you seek capital from banks and other conventional sources, you may find constraints placed on your borrowing. Maybe the size of your operating line of credit will be restricted, or the amount of your term debt will be limited. Risk capital sources will fund businesses that conventional sources will not finance. But they will only do so for a price. They will expect a higher rate of return to compensate for the higher risk. Risk and RateSimply put, risk and rate (that is, rate of return for the investor) go hand in hand. As risk goes up, so does the rate. Why? To compensate for the investor's additional risk. And a higher rate of return means a higher cost to you, to finance your investment needs. Using the types of external financing, see how risk and returns are related. Check It OutCheck your understanding of risk, return and funding options by answering these questions.
1. Why do many companies consider equity the most suitable
option, when it commands such a high rate of return?
2. Which providers of capital prefer lower risk investments?
Which ones are willing to take the higher risks for higher
returns?
3. What are some factors that determine whether risk is higher or lower?
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