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Equity vs. external financing

Recently, lease based on operating lease has been widely used for acquisition of whatever furniture and equipment. Below, you will find a small overview of the company’s capital structure.

Planning strategic company’s capitalisation, the management and the owners ought to pay special attention to several aspects. In essence, the company’s purpose is to ensure the highest possible return on a limited amount of capital, at the same time, accepting the related operational risks agreed upon by the owner. Basically, this means that the owner must always ask themselves if not too many of their assets are attached to the company; if the company’s return on capital is what they have expected; if it can increased improving the capital structure or maybe finding a much more cost-effective capital placement option. It is also of importance whether the owner wishes to accept the risks related to this particular company considering the currently invested amount of money or whether the risks can be reduced implementing adequate methods.

One of the main goals of the company’s manager, who may not be the company’s owner, is to ensure the expected return on owner’s capital, which should preferably exceed the expectations. Thus, the manager’s must also be interested in keeping an equity part of such amount that would allow them to maximise the owner’s revenues.

Undoubtedly, the owners of smaller companies often fail to approach the above-mentioned aspects of capitalisation from such a pragmatic perspective. It might be considered best to introduce as little external financing as possible as this seems easier and cheaper, not being aware that the related risks include a maybe too big share of the assets. Naturally, there are a lot of contrary problems, where a maximum number of loans is taken and investments are made beyond the maximum capacity. An overly large amount of debt makes the company risky, which increases the price of its liabilities, reduces the company’s profits, and, in times of trouble, can lead to bankruptcy. For best results, take a path in between – make optimal use of external financing if it increases return on equity; keep the company out of a certain capital buffer, on the one hand, not to risk all the assets, and, on the other hand, to ensure that the company will be able to support itself on its own equity in rougher times. Such decisions, however, ought to be made in lucrative times only. In times of crisis, the choices become narrower almost instantly.

Under normal circumstances, there is a rule that equity is more expensive than the company’s external financing, taking into account that the company is in no difficulty and does not have too much debt burden. As it is a highly regarded subject, in the context of the company’s financial management, it ought to be determined what the percentage rate of return is that the owner expects on the invested capital per year. In theory, it should consist of the risk-free interest rate prevailing on the market + the risk premium of the respective business industry and the company. The owner’s income expectations must not significantly exceed the return rate of the business activity of the same risk level; whereas there is no reason why it should remain below the rate. What is meant under return is revenue coming from both dividends (or other sources) as well as from the increasing value of the company.

If the expected return on equity is more or less known, the offered and available borrowed capital interest can be estimated. Using the calculated values, the value of the company’s capital can be calculated as well.

Let us bring a simple example of the calculation of capital value (p. concept of WACC – – weighted average cost of capital). The company finances itself:

60% equity – expected profitability 15%

25% loan 1 – interest 9%

15% loan 2 – interest 6%

WACC = 15*0.6 + 9*0.25 + 6*0.15 = 12.15%

Thus, the company’s management ought to take into account that the used capital’s value amounts to 12.15% per year. The company must be able to earn such profit on its own assets during the year, as otherwise, it will not able to increase its value for the owners, which, in turn, may raise questions, such as how to improve general performance, or whether the given course of action has any potential at all.

Each company’s overall financing or making a decision on a new project ought to involve an analysis of what financing method would be the most advantageous taking into consideration the value of the company’s capital.

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