Raising capital is an integral part of any company. However, it is important to understand that there is a cost associated with raising capital that companies need to consider before deciding on their mix of capital sources.
What is Capital
Capital is simply defined as “Borrowed sums or equity with which the firm 's assets are acquired and its operations are funded.” (Financial Capital, nd). Frankly speaking, a company cannot operate without capital so it is a necessity for any company, large or small. Capital is what allows a company to purchase assets like products, machinery that are necessary in generating revenue. Capital is also used for investing purposes, expansion projects and new ventures.
There are three types of capital. First, we have equity capital which is derived from a variety of sources such as owner investments, stocks and bonds, and retained earnings. Second, there is debt capital. Debt capital is money borrowed with the intent of paying it back. It is derived in the form of loans. Third, we have Special Capital or Sweat Equity “which is when an owner bootstraps operations by putting in long hours at a low rate of pay per hour making up for the lack of capital necessary to hire sufficient employees to do the job well and let them work an ordinarily forty hour workweek. It is largely intangible and does not count as financial capital” (The Three Primary Types of Financial Capital, nd).
“The investor-supplied items – debt, preferred stock and common equity – are called capital components.” (Brigham, Houston, 2013 p.339). Naturally, these types of equity come with a cost and the cost of these components is called the compon...
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...ject or comparing two projects. The WACC will help determine if the project is a worthwhile investment for the company.
While the WACC is a very valuable calculation for companies and investors, it is important to note that there are few disadvantages to using it. First, the formula does not apply to privately owned companies. Secondly, there are various methods for calculating the data in the CAPM which may lead to differing results in the WACC.
As we can see, it costs money to raise money. Each capital component has its own specific method for determining its cost and by using a weighted average approach, we can determine the overall cost of raising capital which is important in making business decisions. The weighted average can also help a company maintain its targeted capital structure when deciding on whether or not to engage in a new business venture.
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