What is “Capital”?
Capital refers to the money raised by a company either through debt, equity or a mix of both, in order to fund its business operations and finance future growth. The aim of capital is to generate earnings and maintain growth. The capital that is required to run the day-to-day operations of a business is known as working capital. It comprises of cash or any liquid assets, such as accounts receivable.
Key Learning Points
- Companies can raise capital through two sources – debt and equity. Debt is considered a less costly form of financing than equity.
- Capital structure is the proportion of debt and equity within the total capital of a company.
- Most companies use a combination of debt and equity to fund their operations.
- The weighted average cost of capital (WACC) is the weighted average cost of debt and equity.
Sources of Capital
Businesses can raise capital either through debt, equity, or a combination of both.
Debt is an amount of money borrowed from one party on the condition that the amount borrowed (principal) is repaid later. The providers of debt capital expect to be compensated through periodic or scheduled interest payments and the repayment of principal. Debt is considered a cheaper form of financing than equity.
Equity financing involves firms raising capital by selling shares or an ownership stake in their company. There are many sources of equity financing, such as the personal capital of the business founders, equity capital markets, institutional investors, corporate investors, angel investors, venture capital firms, crowd funding platforms etc.
The two advantages of raising capital through equity financing are: first, companies do not have an obligation to repay shareholders the money raised from investors, and second, there are no fixed costs from having raised equity, whereas there is the cost of interest expense related to debt.
The capital structure is the proportion of debt and equity (i.e. mix of capital) used by a business to finance its overall operations, capital expenditure, investments and other acquisitions. Often, the optimal capital structure of a company is defined as the mix of capital that results in the lowest weighted average of capital (WACC).
Startup/high-growth companies are financed mostly with equity, as they are too risky for banks to lend to. On the other hand, mature companies tend to have a higher proportion of debt in their capital structure, as they have proven their ability to generate cash flows with which they can pay off the debt.
The Cost of Capital
The cost of capital is based on the source of capital. The cost of equity refers to the required return from shareholders, and the cost of debt refers to the required return from debtholders. Most companies use a mix of debt and equity capital for operating and growing their business. In such cases, the cost of capital is calculated as the weighted average cost of debt and equity, known as the weighted average cost of capital (WACC).
The WACC has multiple applications, including in discounted cash flow (DCF) analysis. The valuation of a business using the DCF method is very sensitive to the WACC. A higher WACC would mean a lower valuation and vice versa.
In investment analysis, WACC is used in conjunction with another metric, return on invested capital (ROIC). ROIC is a useful measure of the operational profitability and the efficiency of a business.
If the ROIC of a company is higher than its WACC, this suggests that the company is making returns to investors in excess of its costs, and creating value. It is an indicator of the company investing in value-creating projects i.e. the company is healthy and growing. Investors may want to invest in such a company. On the other hand, if the ROIC is lower than the WACC, it suggests that the company is eroding value and it may be better for investors to invest somewhere else.
Example: Cost of Capital
Let’s calculate a WACC and compare it to the ROIC of a business. Such a comparison helps to determine if an investor should invest in a company or not.
The WACC is calculated as follows:
WACC = ((Cost of debt * Proportion of debt) + (Cost of equity * Proportion of equity))
The proportion of debt is the percentage of debt in the total capital. It is calculated by dividing debt by total capital. The proportion of equity is calculated similarly.
In the table below we see the debt and equity proportions calculated, along with the information required to calculate the WACC.
Using the formula mentioned above, the WACC is calculated as follows:
The ROIC for this investment is 15.0%.
From the table, we can see that the ROIC is higher than the WACC. This indicates that the returns generated by the company are higher than the cost of capital required to generate those returns. Investors are likely to invest in such a company.