Many companies that search for funding only focus on the amount of capital to be raised. But capital is the economic combination of costs and benefits and at times investment terms and conditions can do more harm to a business than good. This article discusses the economic structure of financial capital and argues that companies should take a broad view of capital costs and benefits when raising funds. Ultimately, the objective of capital raising should not merely be to obtain funds but to create shareholder value.
Three Views of Financial Capital
Companies raise capital for many reasons, including to finance operating costs, fund growth plans or even acquire companies. This capital can help companies grow in size, buy time to explore and pivot into new business models or withstand different types of economic shocks.
As a firm asset, there are three general ways to view the financial value of capital. The first way is simply to view capital as a means of exchange with a fixed value. In this view, capital simply represents an amount of funds that can be saved or spent for different purposes.
The second way to view capital is as representing the economic value of what can be purchased or created with capital. If capital is used to buy goods, the value of capital is the value of the goods purchased. If the capital is kept in the bank for a year and earns interest, the value of the capital is the amount of interest earned. If the capital is used to invest in a project and the project generates a return, the value of the capital is the amount of the return. Capital, in other words, represents not a single, fixed economic option but rather a range of value creation possibilities.
Yet these are both limited views of financial capital as a firm asset in the context of corporate finance. Economically, capital should rather be thought of as the combination of the economic costs of capital on the one hand and the economic benefits of capital on the other. In the context of a business, where all firm assets represent a dynamic matrix of costs and benefits, this definition better captures the economic reality of capital and the ability of a firm to create economic value.
The economic value of capital is a combination of the economic cost of the capital and the economic benefits of the capital.
Capital Economic Costs and Benefits
Rather than simply representing a potential economic benefit, capital has many actual and potential costs. For capital raised in the form of debt, these costs include: (i) initial transaction costs; (ii) interest payments; (iii) financing compliance costs; and (v) penalty and exit payments.
Initial Transaction Costs. Initial transaction costs can be divided into two large categories: internal costs and external costs. Internal costs refer to the economic value of firm resources, such as employee time, that are used to raise capital. For capital raising transactions that last many months, the aggregate value of these resources can be significant.
External transaction costs refer to amounts that may need to be paid to the lender at the time of closing such as structuring fees, fees for reports commissioned by the lender and fees that may have to be paid to financial, legal or tax advisors for their advice in connection with the transaction.
Interest Payments. Interest payments refer to the total amount of interest paid over the life of the loan. If interest is paid in a currency other than the borrower’s operating currency, interest rate costs include additional amounts that are required to be paid in the event that the borrower’s currency is devalued relative to the currency the loan payments are denominated in.
Financing Compliance Costs. The cost of compliance with financing arrangements has several different components depending on the lender and the nature of the transaction. The first component is the amount of human or financial resources that are required to comply with positive or negative loan documentation covenants. The second component is the financial costs that a borrower is required to assume over the life of the loan in connection with commissioning required reports, such as the preparation of financial statements, pre-loan drawdown reports or the periodic valuation of assets that are used to guarantee the loan.
Penalty and Exit Payments. Loan penalty and exit payments refer to amounts are required to be paid in the event of late interest or principal payments, loan pre-payment penalties and the costs of unwinding agreements that hedge currency risk or convert floating interest requirements into fixed interest payments.
For transactions in the form of equity, instead of the interest rate, the key economic payments to the investor are: (i) dividends; and (ii) payments that are required to be paid to the investor in the event of any money events that generate funds that can be distributed to shareholders, such as a private share sale or an IPO.
Another potential cost that has to be considered in connection with an equity investment is based on the relationship with the investor. If the investor has a controlling stake in the company, this constitutes a potential cost to the investee company because the investor can take actions that negatively affect the economic interests of the company. For example, an investor may block an action that will favor an investor with a short-term investment horizon (such as cutting costs) but may negatively affect the company’s long-term ability to generate economic value.
On the economic benefit side of the capital value equation, both debt and capital can have significant benefits beyond their face or short-term transactional value. Many financial operations are not simply debit or credit transactions but rather financial events that alter, sometimes very significantly, the internal operating environment of a firm, a firm’s level of resilience or its competitive position. These changes have many primary and secondary economic impacts.
Many financial operations are not simply debit or credit transactions but rather financial events that alter the internal operating environment of a firm, a firm’s level of resilience or its competitive position.
Capital and Shareholder Value
The economic structure of capital has great significance for the creation or loss of shareholder value. If the economic benefits of capital are greater than their costs, shareholder value is created; if they are not, shareholder value is lost. This economic law should serve as a key pillar of any capital raising strategy.
When considering capital costs and benefits, however, what is useful to keep in mind is that shareholder value creation or loss is very often not a discrete event but rather as a process that extends over time: shareholder value creation and loss sets in motion economic processes that make further shareholder value creation or gain more or less likely.
Shareholder value creation or loss is very often not a discrete event but rather a process that extends over time: shareholder value creation and loss sets in motion economic processes that make further shareholder value creation or gain more or less likely.
For example, assume that a financing transaction provides capital that a firm needs in the short term but requires the payment of a very high interest rate. The payment of this interest rate may cause an erosion in the firm’s free cash flows which increases firm risk and causes the cost of its capital to rise further. Apart from creating additional pressure on firm cash flows, this can make it more difficult to invest in new human resources or technology the firm needs to remain competitive. The combination of these factors makes it increasingly likely that firms will lose shareholder value rather than create it.
Conclusion
Capital has the great ability to transform not only the short-term value of a firm but also its long-term value creation trajectory. By taking a broad view of capital costs as well as capital benefits, firms can increase the likelihood that the process of capital raising will create shareholder value rather than cause it to be lost.