Question

How do firms raise capital? What criteria do they use in choosing between different alternative methods?

Answer 1

Companies frequently make choices involving spending cash in the current and expecting future profits. Some examples are: when a company buys a machine that will last 10 years, or builds a fresh plant that will last 30 years, or launches a research and development project. To do this, they need economic resources, also known as financial capital. Companies can increase the financial capital they need to pay for such projects in four primary ways: (1) early-stage investors; (2) reinvesting earnings; (3) borrowing by banks or bonds; and (4) selling stocks. As you will see, each financial option has distinct operational and profit consequences for the company.

Companies that are just starting often have an idea or a prototype to sell a product or service, but they have few customers or even no customers at all, so they don't earn earnings. Banks often refuse to lend cash to start-ups because they are considered too risky. When it comes to raising financial capital, such companies face a challenging issue:

For many tiny companies, the proprietor of the company is the initial source of cash. For example, someone who chooses to begin a restaurant or gas station could cover the start-up expenses by dipping into their own bank account or borrowing cash (maybe using a home as collateral). Alternatively, many towns have a network of well-to - do people, known as "angel investors," who at an early point of growth will put their own cash into tiny new businesses in return for owning a part of the company.

Venture capital firms invest in fresh firms that are still comparatively tiny in size but have significant growth potential. These businesses collect cash from a variety of individual or institutional investors, including banks, institutions such as college endowments, financial-reserve insurance companies, and corporate pension funds. Venture capital companies are doing more than just providing tiny start-ups with cash. They also provide guidance on prospective products, clients, and important staff. A venture capital fund typically invests in a number of companies, and then investors in that fund receive returns based on how the fund performs as a whole.

If companies earn earnings (their sales are higher than expenses), they may choose to reinvest some of these profits in machinery, structures, and R&D. Reinvesting their own earnings is a primary source of financial capital for many established firms. Just starting up companies and companies may have countless appealing investment possibilities but few present revenues to invest.

A bank loan to a company operates in much the same way as a loan to a person purchasing a vehicle or a house. The company borrows an quantity of cash and then promises to repay it over a predetermined period of time, including some interest rate. If the company fails to create credit payments, the bank (or banks) can frequently bring the company to court and require it to sell its houses or machinery to make credit payments.