Capital Managment

1. Theoretical and methodological aspects of enterprise capital management

1.1. Essence of capital as an economic category

The capital of the enterprise characterizes the total cost of funds invested in the formation of its assets. The capital of the enterprise is divided into equity and borrowed capital.

Own capital is understood as a set of economic relations that make it possible to include in the economic turnover financial resources belonging either to the owners or to the economic entity itself.

The role of capital in the economic development of the company determines it as the main object of financial management of the organization.

The level of efficiency of the company's economic activity is largely determined by the purposeful formation of the volume and structure of equity capital. The goal of a firm's equity management is to meet its needs for acquiring the necessary assets and optimize the capital structure to minimize its cost and maximize the value of the firm with an acceptable level of risk.

1.2. The structure of the capital of the enterprise

The capital structure is the ratio of own and borrowed funds used in the course of economic activity. It has an active influence on the level of economic and financial profitability of the organization, determines the system of financial stability ratios and, ultimately, forms the ratio of profitability and risk in the development of the company.

Main sources of funding:

1. Personal investment

When starting a business, your first investor should be yourself—either with your own cash or with collateral on your assets. This proves to investors and bankers that you have a long-term commitment to your project and that you are ready to take risks.

2. Love money

This is money loaned by a spouse, parents, family or friends. Investors and bankers considers this as "patient capital", which is money that will be repaid later as your business profits increase.

When borrowing love money, you should be aware that:

Family and friends rarely have much capital

They may want to have equity in your business

A business relationship with family or friends should never be taken lightly

3. Venture capital

The first thing to keep in mind is that venture capital is not necessarily for all entrepreneurs. Right from the start, you should be aware that venture capitalists are looking for technology-driven businesses and companies with high-growth potential in sectors such as information technology, communications and biotechnology.

Venture capitalists take an equity position in the company to help it carry out a promising but higher risk project. This involves giving up some ownership or equity in your business to an external party. Venture capitalists also expect a healthy return on their investment, often generated when the business starts selling shares to the public. Be sure to look for investors who bring relevant experience and knowledge to your business.

4. Angels

Angels are generally wealthy individuals or retired company executives who invest directly in small firms owned by others. They are often leaders in their own field who not only contribute their experience and network of contacts but also their technical and/or management knowledge. Angels tend to finance the early stages of the business with investments in the order of $25,000 to $100,000. Institutional venture capitalists prefer larger investments, in the order of $1,000,000.

In exchange for risking their money, they reserve the right to supervise the company's management practices. In concrete terms, this often involves a seat on the board of directors and an assurance of transparency.

Angels tend to keep a low profile. To meet them, you have to contact specialized associations or search websites on angels.

5. Business incubators

Business incubators (or "accelerators") generally focus on the high-tech sector by providing support for new businesses in various stages of development. However, there are also local economic development incubators, which are focused on areas such as job creation, revitalization and hosting and sharing services.

Commonly, incubators will invite future businesses and other fledgling companies to share their premises, as well as their administrative, logistical and technical resources. For example, an incubator might share the use of its laboratories so that a new business can develop and test its products more cheaply before beginning production.

Generally, the incubation phase can last up to two years. Once the product is ready, the business usually leaves the incubator's premises to enter its industrial production phase and is on its own.

Businesses that receive this kind of support often operate within state-of-the-art sectors such as biotechnology, information technology, multimedia, or industrial technology.

6. Government grants and subsidies

Government agencies provide financing such as grants and subsidies that may be available to your business.

Criteria

Getting grants can be tough. There may be strong competition and the criteria for awards are often stringent. Generally, most grants require you to match the funds you are being given and this amount varies greatly, depending on the granter. For example, a research grant may require you to find only 40% of the total cost.

Generally, you will need to provide:

A detailed project description

An explanation of the benefits of your project

A detailed work plan with full costs

Details of relevant experience and background on key managers

Completed application forms when appropriate

Most reviewers will assess your proposal based on the following criteria:

Significance

Approach

Innovation

Assessment of expertise

Need for the grant

Some of the problem areas where candidates fail to get grants include:

The research/work is not relevant

Ineligible geographic location

Applicants fail to communicate the relevance of their ideas

The proposal does not provide a strong rationale

The research plan is unfocused

There is an unrealistic amount of work

Funds are not matched

7. Bank loans

Bank loans are the most commonly used source of funding for small and medium-sized businesses. Consider the fact that all banks offer different advantages, whether it's personalized service or customized repayment. It's a good idea to shop around and find the bank that meets your specific needs.

In general, you should know bankers are looking for companies with a sound track record and that have excellent credit. A good idea is not enough; it has to be backed up with a solid business plan. Start-up loans will also typically require a personal guarantee from the entrepreneurs.

1.3. Optimal Capital Structure

The optimal capital structure of a firm is the best mix of debt and equity financing that maximizes a company’s market value while minimizing its cost of capital. In theory, debt financing offers the lowest cost of capital due to its tax deductibility. However, too much debt increases the financial risk to shareholders and the return on equity that they require. Thus, companies have to find the optimal point at which the marginal benefit of debt equals the marginal cost.

KEY TAKEAWAYS

An optimal capital structure is the best mix of debt and equity financing that maximizes a company’s market value while minimizing its cost of capital.

Minimizing the weighted average cost of capital (WACC) is one way to optimize for the lowest cost mix of financing.

According to some economists, in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, in an efficient market, the value of a firm is unaffected by its capital structure.

1.4. Understanding Optimal Capital Structure

The optimal capital structure is estimated by calculating the mix of debt and equity that minimizes the weighted average cost of capital (WACC) of a company while maximizing its market value. The lower the cost of capital, the greater the present value of the firm’s future cash flows, discounted by the WACC. Thus, the chief goal of any corporate finance department should be to find the optimal capital structure that will result in the lowest WACC and the maximum value of the company (shareholder wealth).

According to economists Franco Modigliani and Merton Miller, in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, in an efficient market, the value of a firm is unaffected by its capital structure

1.5. Optimal Capital Structure and WACC

The cost of debt is less expensive than equity because it is less risky. The required return needed to compensate debt investors is less than the required return needed to compensate equity investors, because interest payments have priority over dividends, and debt holders receive priority in the event of a liquidation. Debt is also cheaper than equity because companies get tax relief on interest, while dividend payments are paid out of after-tax income.

However, there is a limit to the amount of debt a company should have because an excessive amount of debt increases interest payments, the volatility of earnings, and the risk of bankruptcy. This increase in the financial risk to shareholders means that they will require a greater return to compensate them, which increases the WACC—and lowers the market value of a business. The optimal structure involves using enough equity to mitigate the risk of being unable to pay back the debt—taking into account the variability of the business’s cash flow.

Companies with consistent cash flows can tolerate a much larger debt load and will have a much higher percentage of debt in their optimal capital structure. Conversely, a company with volatile cash flows will have little debt and a large amount of equity.

1.6. Determining the Optimal Capital Structure

As it can be difficult to pinpoint the optimal capital structure, managers usually attempt to operate within a range of values. They also have to take into account the signals their financing decisions send to the market.

A company with good prospects will try to raise capital using debt rather than equity, to avoid dilution and sending any negative signals to the market. Announcements made about a company taking debt are typically seen as positive news, which is known as debt signaling. If a company raises too much capital during a given time period, the costs of debt, preferred stock, and common equity will begin to rise, and as this occurs, the marginal cost of capital will also rise.

To gauge how risky a company is, potential equity investors look at the debt/equity ratio. They also compare the amount of leverage other businesses in the same industry are using—on the assumption that these companies are operating with an optimal capital structure—to see if the company is employing an unusual amount of debt within its capital structure.

Another way to determine optimal debt-to-equity levels is to think like a bank. What is the optimal level of debt a bank is willing to lend? An analyst may also utilize other debt ratios to put the company into a credit profile using a bond rating. The default spread attached to the bond rating can then be used for the spread above the risk-free rate of a AAA-rated company.

1.7. Limitations of Optimal Capital Structure

Unfortunately, there is no magic ratio of debt to equity to use as guidance to achieve real-world optimal capital structure. What defines a healthy blend of debt and equity varies according to the industries involved, line of business, and a firm's stage of development, and can also vary over time due to external changes in interest rates and regulatory environment.

However, because investors are better off putting their money into companies with strong balance sheets, it makes sense that the optimal balance generally should reflect lower levels of debt and higher levels of equity.