💳Principles of Finance Unit 17 – How Firms Raise Capital

Key Concepts and Terminology

• Capital refers to the financial resources a company uses to fund its operations and growth
• Financing is the process of obtaining funds for business activities, investments, or projects
• Debt financing involves borrowing money that must be repaid with interest over a specified period
• Equity financing involves selling ownership stakes in the company to investors in exchange for capital
• Leverage is the use of borrowed money to finance assets or investments
• Cost of capital represents the required rate of return for a company's investors and lenders
• Capital structure is the mix of debt and equity a company uses to finance its operations and growth
• Weighted Average Cost of Capital (WACC) calculates a firm's average cost of financing, considering the proportions of debt and equity in its capital structure

Sources of Capital

• Internal financing uses funds generated from a company's operations, such as retained earnings or cash reserves
• External financing obtains funds from sources outside the company, such as banks, investors, or capital markets
• Short-term financing provides funds for a period of less than one year (working capital, accounts receivable financing)
• Long-term financing provides funds for a period exceeding one year (bonds, loans, leases)
• Debt financing includes borrowing money from banks, issuing bonds, or obtaining loans from other financial institutions
• Equity financing involves selling ownership stakes in the company to investors, such as through the issuance of common or preferred stock
• Hybrid securities combine characteristics of both debt and equity (convertible bonds, preferred stock)
• Crowdfunding platforms allow companies to raise capital from a large number of individuals, typically via the internet

Equity Financing

• Common stock represents ownership in a company and entitles shareholders to vote on corporate matters and receive dividends
• Preferred stock provides a fixed dividend and takes priority over common stock in the event of liquidation but typically does not carry voting rights
• Venture capital firms invest in early-stage, high-growth potential companies in exchange for equity ownership
• Angel investors are high-net-worth individuals who provide capital to startups in exchange for equity
• Private equity firms invest in mature companies, often to improve operations and increase value before selling their stake
• Rights offerings allow existing shareholders to purchase additional shares at a discounted price to maintain their ownership percentage
• Stock options give employees the right to purchase company stock at a predetermined price, aligning their interests with shareholders
• Dilution occurs when a company issues new shares, reducing the ownership percentage of existing shareholders

Debt Financing

• Bonds are debt securities that obligate the issuer to make periodic interest payments and repay the principal at maturity
• Bank loans provide capital with fixed or variable interest rates and repayment terms
• Revolving credit facilities allow companies to borrow and repay funds as needed, up to a predetermined limit
• Commercial paper is a short-term, unsecured promissory note issued by companies with high credit ratings
• Debentures are unsecured bonds backed only by the creditworthiness of the issuer
• Mortgage loans are secured by real estate, with the property serving as collateral
• Mezzanine financing is a hybrid of debt and equity, often used to fund acquisitions or growth
• Syndicated loans involve multiple lenders providing funds to a single borrower, spreading the risk among participants

Initial Public Offerings (IPOs)

• An IPO is the first sale of a company's stock to the public, allowing it to raise capital from a broad base of investors
• Underwriters (investment banks) manage the IPO process, setting the initial price and facilitating the sale of shares
• A prospectus is a legal document that provides potential investors with information about the company and the offering
• The primary market is where securities are first issued and sold to investors
• The secondary market is where previously issued securities are traded among investors (stock exchanges)
• Lockup periods prevent insiders from selling their shares for a specified time after the IPO to stabilize the stock price
• Greenshoe options allow underwriters to sell additional shares if demand exceeds the initial offering
• Direct listings allow companies to list their shares on an exchange without raising new capital or using underwriters

Capital Structure Decisions

• The optimal capital structure minimizes the weighted average cost of capital (WACC) and maximizes firm value
• Trade-off theory suggests that companies balance the benefits of debt (tax shield) against the costs (financial distress, agency costs)
• Pecking order theory proposes that companies prefer internal financing, followed by debt, and then equity as a last resort
• Financial leverage increases the potential return on equity but also amplifies risk
• Interest tax shield refers to the tax deductibility of interest expenses, which can lower a company's cost of debt
• Debt covenants are restrictions placed on borrowers by lenders to protect their interests
• Asset-backed securities (ABS) are financial instruments collateralized by a pool of assets, such as loans or receivables
• Credit ratings assess a borrower's creditworthiness and ability to repay debt, influencing the cost of borrowing

Pros and Cons of Different Financing Methods

• Debt financing allows companies to maintain ownership control but requires regular interest payments and principal repayment
• Equity financing does not require repayment but dilutes ownership and may necessitate sharing control with new investors
• Internal financing preserves ownership and avoids the costs of external financing but may limit growth opportunities
• Short-term financing provides flexibility but may expose the company to interest rate risk and refinancing risk
• Long-term financing offers stability but may lock the company into unfavorable terms if market conditions change
• Issuing convertible securities can lower the cost of financing but may lead to dilution if the options are exercised
• Crowdfunding can provide access to a large pool of investors but may be subject to regulatory constraints and public scrutiny
• Leasing allows companies to acquire assets without upfront capital expenditures but may result in higher total costs over the life of the asset

Real-World Examples and Case Studies

• In 2019, Saudi Aramco raised $25.6 billion in the world's largest IPO, valuing the company at$1.7 trillion
• Tesla has relied on a mix of debt, equity, and convertible securities to finance its growth and expansion
• Apple has used its substantial cash reserves and strong credit rating to issue bonds and fund share buybacks and dividends
• WeWork's failed IPO in 2019 highlighted the risks of overvaluation and the importance of sound corporate governance
• Airbnb's IPO in 2020 demonstrated the resilience of its business model amid the COVID-19 pandemic
• Green bonds have gained popularity as a way for companies to finance environmentally friendly projects and appeal to socially conscious investors
• The leveraged buyout (LBO) of RJR Nabisco in 1989 remains one of the most famous examples of using debt to acquire and restructure a company
• Kickstarter has helped numerous startups and creative projects raise capital through rewards-based crowdfunding campaigns