Funding Operations With Capital
Running a business requires a great deal of capital. Capital can take different forms, from human and labor capital to economic capital. But when most people hear the term "financial capital," the first thing that comes to mind is usually money.
That's not necessarily untrue. Financial capital is represented by assets, securities, and yes, cash. Having access to cash can mean the difference between companies expanding or staying behind and being left in the lurch. But how can companies raise the capital they need to keep them going and to fund their future projects? And what options do they have available?
There are two types of capital that a company can use to fund operations: debt and equity. Prudent corporate finance practice involves determining the mix of debt and equity that is most cost-effective. This article examines both kinds of capital.
- Businesses can use either debt or equity capital to raise money, where the cost of debt is usually lower than the cost of equity, given debt has recourse.
- Debt capital comes in the form of loans or issues of corporate bonds. Equity capital comes in the form of cash in exchange for company ownership, usually through stocks.
- Debt holders usually charge businesses interest, while equity holders rely on stock appreciation or dividends for a return.
- Preferred equity has a senior claim on a company’s assets compared to common equity, making the cost of capital lower for preferred equity.
Debt capital is also referred to as debt financing. Funding by means of debt capital happens when a company borrows money and agrees to pay it back to the lender at a later date. The most common types of debt capital companies use are loans and bonds, which larger companies use to fuel their expansion plans or to fund new projects. Smaller businesses may even use credit cards to raise their own capital.
A company looking to raise capital through debt may need to approach a bank for a loan, where the bank becomes the lender and the company becomes the debtor. In exchange for the loan, the bank charges interest, which the company will note, along with the loan, on its balance sheet.
The other option is to issue corporate bonds. These bonds are sold to investors—also known as bondholders or lenders—and mature after a certain date. Before reaching maturity, the company is responsible for issuing interest payments on the bond to investors.
Rating agencies, such as Standard and Poor's (S&P), are responsible for rating the quality of corporate debt, signaling to investors how risky the bonds are.
Pros and Cons of Debt Capital
Because corporate bonds generally come with a high amount of risk—the chances of default are higher than bonds issued by the government—they pay a much higher yield. The money raised from bond issuance can be used by the company for its expansion plans.
While this is a great way to raise much-needed money, debt capital does come with a downside: It comes with the additional burden of interest. This expense, incurred just for the privilege of accessing funds, is referred to as the cost of debt capital. Interest payments must be made to lenders regardless of business performance. In a low season or bad economy, a highly leveraged company may have debt payments that exceed its revenue.
Example of Debt Capital
Let's look at the loan scenario as an example. Assume a company takes out a $100,000 business loan from a bank that carries a 6% annual interest rate. If the loan is repaid one year later, the total amount repaid is $100,000 x 1.06, or $106,000. Of course, most loans are not repaid so quickly, so the actual amount of compounded interest on such a large loan can add up quickly.
Equity capital, on the other hand, is generated not by borrowing, but by selling shares of company stock. If taking on more debt is not financially viable, a company can raise capital by selling additional shares. These can be either common shares or preferred shares.
Common stock gives shareholders voting rights but doesn't really give them much else in terms of importance. They are at the bottom of the ladder, meaning their ownership isn't prioritized as other shareholders are. If the company goes under or liquidates, other creditors and shareholders are paid first. Preferred shares are unique in that payment of a specified dividend is guaranteed before any such payments are made on common shares. In exchange, preferred shareholders have limited ownership rights and have no voting rights.
Debt holders are generally known as lenders, while equity holders are known as investors.
Pros and Cons of Raising Equity
The primary benefit of raising equity capital is that, unlike debt capital, the company is not required to repay shareholder investment. Instead, the cost of equity capital refers to the amount of return on investment shareholders expect based on the performance of the larger market. These returns come from the payment of dividends and stock valuation.
The disadvantage to equity capital is that each shareholder owns a small piece of the company, so ownership becomes diluted. Business owners are also beholden to their shareholders and must ensure the company remains profitable to maintain an elevated stock valuation while continuing to pay any expected dividends.
Because preferred shareholders have a higher claim on company assets, the risk to preferred shareholders is lower than to common shareholders, who occupy the bottom of the payment food chain. Therefore, the cost of capital for the sale of preferred shares is lower than for the sale of common shares. In comparison, both types of equity capital are typically more costly than debt capital, since lenders are always guaranteed payment by law.
Example of Equity Capital
As mentioned above, some companies choose not to borrow more money to raise their capital. Perhaps they're already leveraged and just can't take on any more debt. They may turn to the market to raise some cash.
A startup company may raise capital through angel investors and venture capitalists. Private companies, on the other hand, may decide to go public by issuing an initial public offering (IPO). This is done by issuing stock on the primary market—usually to institutional investors—after which shares are traded on the secondary market by investors. For example, Facebook went public in May 2012, raising $16 billion in capital through its IPO, which put the company's value at $104 billion.
The Bottom Line
Companies can raise capital through either debt financing or equity financing. Debt financing requires borrowing money from a bank or other lender or issuing corporate bonds. The full amount of the loan has to be paid back, plus interest, which is the cost of borrowing.
Equity financing involves giving up a percentage of ownership in a company to investors, who purchase shares of the company. This can either be done on a stock market for public companies, or for private companies, via private investors that receive a percentage of ownership.
Both types of financing have their pros and cons, and the right choice, or the right mix, will depend on the type of company, its current business profile, its financing needs, and its financial condition.