Question

What is the best way to raise capital for a small company organized as a corporation that has a stock market listing (public company)? The "best" way to raise capital may not be the method with the lowest cost of capital. Each type of capital: bonds (debt), preferred shares, and common shares, come with their own longer-term advantages and disadvantages.

Answer 1

Answer:-

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.

Top Two Ways Corporations Raise Capital are Debt capital and Equity capital:-

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.

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.

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.

Debtholders are generally known as lenders, while equity holders are known as investors.

The capital structure of comapny shall be optimum mix of debt and equity.

best way to raise capital for a small company is optimum combinationI(mix) of debt and equity both.The factor of cost of capital is variable in nature, it may very as market changes.

Advantage of debt capital are as follows:-

You Won’t Give Up Business Ownership
To begin with, one major advantage of debt financing is that you won’t be giving up ownership of the business. When you take out a loan from a financial institution or alternative lender, you’re obligated to make the payments on time for the life of the loan, that’s it. In contrast, if you give up equity in the form of stock in exchange for funding, you might find yourself unhappy about input from outside parties regarding the future of your business.

There are Tax Deductions
A strong advantage of debt financing is the tax deductions. Classified as a business expense, the principal and interest payment on that debt may be deducted from your business income taxes. Pro tip: always check with a tax professional or other financial planner to help answer specific questions about how debt affects your taxes.

Low Interest Rates are Available
Credit cards, peer-to-peer lending, short-term loans, and other debt financing isn’t helpful if the interest rates are sky-high. However, there is good news. A Small Business Administration (SBA) loan is a great option for low-cost funds. With long terms and low rates, an SBA loan is the gold standard for low-cost financing. If you don’t qualify for an SBA loan, there are plenty of other options out there. Just be mindful of the true cost of that loan. Work with a lender who practices complete transparency so you don’t get trapped in a cycle of borrowing. Understand your total payment, both interest and amortization. A good rule of thumb is if you typically have more than one payment per month or if the payment calculation is overly complicated, beware and take care not to move forward.

Debt Can Fuel Growth
Uses of long-term debt include buying inventory or equipment, hiring new workers, and increasing marketing. Taking out a low-interest, long-term loan can give your company working capital needed to keep running smoothly and profitably year round. Think of it as the difference of being able to go that extra mile in your business and make additional profits, opposed to being tied down to a cash-strapped venture that will never be able to get ahead.

Disadvantage of debt capital are as follows:-

You Must Repay the Lender (even if your business goes bust)
When you work with a lender, the rules are pretty clear: You must pay back the loan at the terms agreed upon. That means, even if your business goes under, you still have to make payments. Since most lenders require you to guarantee the loan, your assets could be sold to satisfy your debt.

High Rates
Unfortunately, predatory lenders exist and the techniques they use to rope in unsuspecting small business owners are getting more and more sophisticated. It’s definitely not an advantage of debt financing, but it is something to be aware of. Instead of disclosing the true cost of a loan, some unscrupulous lenders will use methods other than APR. Make sure you are working with a lender who practices transparency and will give you honest numbers. Know both your loan APR and your loan payment and compare it to your original balance.

It Impacts Your Credit Rating
Each loan you take out for your small business will be noted on your credit rating. Beware; this can cause your scores to drop. So before you apply for a loan, check with your lender to determine if the credit check performed to prequalify will affect your score.

You’ll Need Collateral
One of the “5 Cs” of lending is collateral. The collateral as an additional form of security that can be used to assure a lender that you have a second source of loan repayment. If an asset can be sold by the bank for cash, it’s considered collateral. Items like equipment, buildings and (in some cases) inventory qualify. Collateral reduces the risk to a lender and is required for many types of loans. The amount of collateral a borrower has to put up is usually related to the size of the loan. Often, this is seen as a negative by some borrowers.

Advantage of preference shares are as follows:-

NO LEGAL OBLIGATION FOR DIVIDEND PAYMENT

There is no compulsion of payment of preference dividend because nonpayment of dividend does not amount to bankruptcy. This dividend is not a fixed liability like the interest on the debt which has to be paid in all circumstances.

IMPROVES BORROWING CAPACITY

Preference shares become a part of net worth and therefore reduces debt to equity ratio. This is how the overall borrowing capacity of the company increases.

NO DILUTION IN CONTROL

Issue of preference share does not lead to dilution in control of existing equity shareholders because the voting rights are not attached to the issue of preference share capital. The preference shareholders invest their capital with fixed dividend percentage but they do not get control rights with them.

NO CHARGE ON ASSETS

While taking a term loan security needs to be given to the financial institution in the form of primary security and collateral security. There are no such requirements and therefore, the company gets the required money and the assets also remain free of any kind of charge on them.

disadvantage of preference shares are as follows:-

COSTLY SOURCE OF FINANCE

Preference shares are considered a very costly source of finance which is apparently seen when they are compared with debt as a source of finance. The interest on the debt is a tax-deductible expense whereas the dividend of preference shares is paid out of the divisible profits of the company i.e. profit after taxes and all other expenses. For example, the dividend on preference share is 9% and an interest rate on debt is 10% with a prevailing tax rate of 50%.

SKIPPING DIVIDEND DISREGARD MARKET IMAGE

Skipping of dividend payment may not harm the company legally but it would always create a dent on the image of the company. While applying for some kind of debt or any other kind of finance, the lender would have this as a major concern. Under such a situation, counting skipping of dividend as an advantage is just a fancy. Practically, a company cannot afford to take such a risk.

PREFERENCE IN CLAIMS

Preference shareholders enjoy a similar situation like that of an equity shareholder but still gets a preference in both payment of their fixed dividend and claim on assets at the time of liquidation.

Advantages of Common Stock are as follows:-

Equity ownership provides the highest rate of return in the long run; more than bonds and cash. Common stocks have provided over a 6% real rate of return in the long run, providing one of the best means to stay ahead of inflation.

Stock ownership is one of the foundations of capitalism and a free enterprise system. Common stock provides benefits to the issuer, shareholder, and society in general.

The issuer raises capital for producing goods or services. The shareholder receives the fractional benefits of an enterprise that is much larger than they would normally be able to participate in. Society enjoys the benefits of the goods and services of the issuing company as well as the jobs produced by the company. And let’s not forget the taxes paid by both the company and shareholders.

disadvantages of Common Stock are as follows:-

Owners of common stock have no guarantees, but are accepting the risk in exchange for potential greater gains than other safer investments. However, the shareholder’s liability is limited to the price paid for the common stock.

Common stock can be very volatile and is generally considered a high risk investment class. In the case of liquidation of the business, owners of common stock are last in line behind creditors, bondholders, and preferred stockholders.

The price a common stock can trade for more or less than its real or intrinsic value. This is why it is important to understand the value of any stock you purchase. In order to reduce the risk of owning common stock, you want to purchase the stock at a discount to its intrinsic value.

If you can buy a stock for less than its real value the difference between the price you paid and its real value is called the margin of safety. The larger the margin of safety the less risk and the greater potential reward in holding that investment.

All investors with a long term investment horizon should consider owning common stock. The advantages of owning stock far outweigh the risks for investors who are willing do their homework, look for value, and accept a long term investment horizon.