Corporate Debt Vs. Equity Financing
Corporations finance themselves through cash flow from operations, debt, and equity financing. Debt and equity financing is typically necessary to turbocharge growth. Corporate insiders and investors alike often highlight capital structure, as what separates a successful enterprise away from business failure and bankruptcy.
To raise cash, corporations sell both debt and equity to investors. Creditors lend money to corporations and expect for principal to be repaid, with interest. Large corporations sell shares of stock through initial public offerings (IPOs). Shareholders put up cash, in exchange for ownership rights. Shareholders elect a board of directors, who in turn, hire executives to run the business.
A corporation is contractually obligated to pay interest and make good on all debt, while shareholders receive no such guarantees. Bondholders are to be paid first, in the event of bankruptcy. For this, bonds are the much more conservative investment, while share prices regularly fluctuate between zero and infinity.
The Balance Sheet
The balance sheet equation shows that assets equal liabilities plus shareholder’s equity. Again, corporations sell debt and equity, in exchange for cash. Commercial paper, mortgages, bonds, preferred shares, and common stock represent different classifications of debt and equity securities.
Cash raised will be spent upon property, plant, and equipment, on the asset side of the ledger. Profits will ultimately be either reinvested back into the business or returned to shareholders through cash dividends and stock buybacks. Apple, Microsoft, and Berkshire Hathaway are all notable for fortress balance sheets, with hundreds of billions of dollars in cash and securities above minimal debt.
The weighted average cost of capital (WACC) is one of the more important statistics in finance, as it calculates the total costs of financing as a percentage, by multiplying expected returns of debt and equity according to proportion of the capital mix. For real growth, approved projects must turn a return on investment above WACC.