How do companies raise money?

This week in lectures, I was introduced to the concept of “raising finance for multinational enterprises, collaborative ventures and foreign subsidiaries”. This is huge topic which covers several aspects of the way companies raise finance, going from a really technical approach to a more legal way of handling this issue.

In this post, I will try to give an overview of how companies raise money. However, other issues arise when talking about raising money. Where does this money come from in the first place? Is it fair? Are the people from whom the money comes from the one who will benefit for the returns?

According to Savage (2008), there are as many reasons for companies to seek for money that they have ways to raise funds by themselves. Indeed, companies can raise cash like selling assets or division, increasing prices and/or sales… The most used ways to raise money for firm are called “debt finance” and “equity finance”, the last one being the principal way for profit shortfalls, internally generated growth opportunities, investment in immaterial resources and when other solutions are likely to be more expensive in term of cost of capital (Gatchev, Spindt and Tarhan, 2009). But which one is the best way to raise finance for a company?

Both “debt finance” and “equity finance” have their pros and cons, so the best way to choose will depend of the company and the investment it wishes to make. We can’t make a rule dictating when choosing debt finance or equity finance. However, companies have several tools to help them decide.

The most commonly used in these circumstances is the WACC, or Weighted Average Cost of Capital. According to Arnold (2008), the weighted average cost of capital, or discount rate, is “calculated by weighting the cost of debt and equity in proportion to their contributions to the total capital of the firm”. In other words, that means that debt and equity have their own cost in the firm’s capital and the WACC is an overall cost, taking in account the weight of both way of finance. But is it useful? To whom are the benefits for? (If there are benefits…) Is it a good idea to rely only on this indicator? The following video answer these questions.

Let’s now take the example of Kraft. When Kraft Foods bought Cadbury, they had to plan how they will finance the acquisition. As I said before, there is two major ways of raising capital (debt and equity), each with their own advantages and disadvantages. Going back to Savage (2008) description of all these pros and cons, I think that in order to reduce risks linked to debt or equity, companies should have a balance between these two modes. Indeed, when debt shows a major disadvantage, in the same situation, equity seems to offer a solution, and vice versa. Therefore, they did well by borrowing money from banks, thanks to syndicated loans, and creating new shares for other shareholders.

In conclusion, I think that companies should try to maintain a balance between debt and equity, even if that means sometimes that they are not creating the maximum value the shareholders.