Top Two Ways Corporations Raise Capital

BUSINESS CORPORATE FINANCE & ACCOUNTING
Top Two Ways Corporations Raise Capital
BY CLAIRE BOYTE-WHITE | Updated Sep 29, 2019
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 of us hear the term financial
capital, the first thing that comes to mind is usually money. While it can mean different
things, it isn't 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, and how........
KEY TAKEAWAYS
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 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
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—the two most
common ways 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. Because they 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 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.
Now let's take a look at an example of bonds as debt capital. Company A is an airline
company that wants to finance a series of purchases for some new aircraft. Instead of going
to the banks for a loan, the company may decide to issue debt in the form of bonds that
mature within ten years. Investors can purchase these bonds in exchange for interest
payments.
Important: Lenders are guaranteed payment on outstanding debts even in the

absence of adequate revenue.
Equity Capital
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.
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.
FAST FACT
Debtholders are generally known as lenders, while equity
holders are known as investors.
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.
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BUSINESS CORPORATE FINANCE & ACCOUNTING

Top Two Ways Corporations Raise Capital

BY CLAIRE BOYTE-WHITE | Updated Sep 29, 2019

Example of Debt Capital

Important: Lenders are guaranteed payment on outstanding debts even in the

Example of Equity Capital

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