Raising finance and the cost of capital

Finance can be raised either internally or externally by businesses. Raising finance internally involves using retained earnings gained over previous years to finance new projects, this is an option available to companies who hold a lot of cash, however not every business is in such a position. This blog will focus on the process raising finance externally and the cost of raising this capital. External finance comes in two forms, equity finance and debt finance.

Equity finance mainly involves issuing shares in the company in exchange for money. The money raised from the issuing of these shares can then be made available to the company to finance new projects for example. Facebook is a company currently in the headline for it's IPO (initial public offering). On 1st February 2012 Facebook announced it's IPO, and is expected to offer up to $5bn. However, one may ask is this public offering necessary? Facebook is already a very profitable company and it is difficult to see what it would do with this money seeing as it already seems to be making enough to fund future projects.

Would it not be in a position to raise finance internally if it needed to fund a future project? 
Is this decision just a way a increasing the value of the company?If the money raised from the IPO was just invested in the bank for example, it could be argued that this is not good use of shareholder funds. Also it is important to note the value of Facebook as being anywhere between $75bn and $100bn. This means the $5bn being offered makes it a relatively small IPO in comparison to the value of the company, with only between 5% to 7% of the shares being made publicly available. This again could be seen as a way of increasing the value of the company by the current shareholders without giving up much control.

Another recent example of a company raising finance through issuing shares, but with a different aim is General Motors IPO in 2010. This has been the biggest IPO to date, valued at $23.1bn, however this followed the company filing for Chapter 11 bankruptcy. The decision to list the company publicly was taken in order to raise money to pay back the US government who had helped finance General Motors with over $9bn in bid to help restructure the company in return for a stake of 66%.
Following the IPO, the US government's stake was reduced to 26.5%   and recently the company announced it's highest ever profit of $7.6bn.

Another form of finance available for companies is debt finance. Debt finance involves raising money using a number if financial instruments such as loans and issuing bonds to individuals or institutional investors. In return for lending the money (either through a loan or bond) the investor is promised by the business that they will pay back the principal and interest of the loan/bond over an agreed period of time. One difference to note between equity and debt finance is that shareholders are not guaranteed to receive even their original investment back after purchasing shares. Any money made from investing in shares will depend on the future success of the company, whereas the company is obliged to pay back money borrowed from issuing bonds or taking out a loan. Companies often use a mix of equity and debt capital in order to finance future projects.

It is important to consider the cost of capital when discussing the raising of finance. Glen Arnold defines the cost of capital as,

"the rate of return that a company has to offer finance providers to induce them to buy and hold a financial security. This rate is determined by the returns offered on alternative securities with the same risk."

Many companies use the weighted average cost of capital (WACC) in order to identify the minimum return needed from its own investments to satisfy the lenders who have invested in the company. The WACC identifies the average of the costs of the sources of finance used by the company (either debt or equity finance or a combination of the two) and proportionately weighs each cost with the appropriate source of finance. By calculating the WACC, a company can identify how much interest it must pay for every pound/dollar it raises.

Despite being able to identify the required returns to satisfy shareholders, many companies continue to pursue projects that offer returns much lower than the desired figure calculated by the WACC. This is often referred to as a 'loss leader' approach and has been adopted by a number of companies such as airline despite it potentially being a shareholder wealth destroying activity.

Why would a company act in such a way? Well there are a number of reasons. One is to price their competitors out of the market in the hope that they will be unable to compete in the future and allow them to then increase their prices once they have reduced the competition.

This was true in the case of Ryan Air who have often reduced their air fares to extremely low levels when faced with increased competition from other companies such as Aer Lingus. Another airline called 'Go' also tried to offer low cost fares from RyanAir's base in Dublin but ended up withdrawing it's services after RyanAir reduced it's own fares.

It is clear to see that there are a number of different options that companies are faced with when considering the raising of finance and also many different reasons why a company would want to in the first place, not always to fund future projects as in the case of General Motors!