Capital Funding?

Capital funding is the money lenders and equity holders provide to a business for daily and long-term needs. A company's capital funding comprises debt (bonds) and equity (stock). The business uses this money for operating capital. The bond and equity holders expect to earn a return on their investment through interest, dividends, and stock appreciation.

Understanding Capital Funding

Businesses usually raise funds through capital funding programs to acquire capital or fixed assets, such as land, buildings, and machinery, to purchase these assets. A business can take two primary routes to access funding: raising capital through stock issuance and raising capital through debt.

Stock Issuance

A company can issue common stock through an initial public offering (IPO) or by issuing additional shares into the capital markets. Either way, the money provided by investors who purchase the shares is used to fund capital initiatives. In return for providing capital, investors demand a return on their investment (ROI), a cost of equity to a business. The return on investment can be provided to stock investors by paying dividends or by effectively managing the company's resources to increase the value of the shares held by these investors.

One drawback of this source of capital funding is that issuing additional funds in the markets dilutes the holdings of existing shareholders as their proportional ownership and voting influence within the company will be reduced.

Debt Issuance

Capital funding can also be acquired by issuing retail and institutional investors corporate bonds. When companies issue bonds, they borrow from investors compensated with semi-annual coupon payments until the bond matures. The coupon rate on a bond represents the cost of debt to the issuing company.

In addition, bond investors may be able to purchase a bond at a discount, and the face value of the bond will be repaid when it matures. For example, an investor who buys a bond for $910 will receive a payment of $1,000 when the bond matures.

Special Considerations

Loans can also raise capital funding through debt from banks or other commercial lending institutions. These loans are recorded as long-term liabilities on a company's balance sheet and decrease as the loan is gradually paid off. The loan's borrowing cost is the interest rate that the bank charges the company. The interest payments that the company makes to its lenders are considered an expense on the income statement, which means pre-tax profits will be lower.

While a company is not obligated to pay its shareholders, it must fulfill its interest and coupon payment obligations to its bondholders and lenders, making capital funding through debt a more expensive alternative than through equity. However, if a company goes bankrupt and has its assets liquidated, its creditors will be paid off first before shareholders are considered.

There are two key ways a business can access funding: by raising capital through issuing stock and by raising capital through issuing debt.

Cost of Capital Funding

Companies usually analyze the cost of receiving capital through equity, bonds, bank loans, venture capitalists, asset sales, and retained earnings extensively. A business may assess its weighted average cost of capital (WACC), which weights each cost of capital funding, to calculate its average cost of capital.

The WACC can be compared to the return on invested capital (ROIC)—the return that a company generates when it converts its capital into capital expenditures. If the ROIC exceeds the WACC, the company will move forward with its capital funding plan. If it's lower, the business must re-evaluate its strategy and re-balance the proportion of needed funds from the various capital sources to decrease its WACC.

Examples of Capital Funding

Some companies exist solely to provide capital funding to businesses. Such a company might specialize in funding a specific category of companies, such as healthcare companies or a specific type of company, such as assisted living facilities. The capital funding company might also operate to provide only short-term and/or long-term financing to a business. These companies, such as venture capitalists, could also choose to focus on funding a certain stage of the business, such as a business that is just starting up.