Last updated on June 24th, 2024 at 11:12 am
Effective capital structure optimisation and capital raising strategies are crucial in shaping a company's financial health and growth prospects and are important aspects of investment banking.
The composition of a company's debt and equity, known as its capital structure, significantly impacts its ability to finance operations, pursue strategic initiatives, and maximise shareholder value. This blog explores the key considerations and strategies involved in capital structure optimisation and capital raising, considering the nuances of financial flexibility, fiscal discipline, risk management, and growth aspirations.
Capital Optimisation
Capital optimisation refers to managing and balancing the receivables and payables of an organisation. An organisation can establish a practical solution with minimal disruption while accomplishing the desired effect with capital optimisation. Usually, an optimal capital structure of an organisation is the perfect balance of equity and debt.
For an organisation, debt is cheaper than equity as it costs less in repayment. However, debt can also cause an organisation to go bankrupt. Organisations must find the point at which the benefit of debt equals the cost of operation.
How to optimise a capital structure?
Deciding an optimal capital structure for an organisation can be very difficult. Before making the final call, managers must consider the impact of their decision on the market.
The most practical approach for a company is to raise capital using debt rather than equity, as debt signalling is positive news. Additionally, debt is cheaper than equity as companies get tax relief on interest.
On the other hand, raising capital through equity can cause dilution and is considered a negative signal. Equity is also costlier because the company pays the dividend from the after-tax income.
The debt or interest tax shield is a significant solution for optimising capital structure. It helps reduce the tax amount from the debt interest payments. The calculation process of the tax shield is given below.
Interest tax shield = Interest expense deduction ✕ Effective tax rate
Capital Raising
Capital raising is the procedure an organisation undertakes to acquire funds required for new projects and expand old projects and businesses.
The organisation can issue stocks or bonds to its investors in exchange for their investment in the company to raise capital. These stocks usually offer the investors a share in the company.
There are various ways to implement successful capital raising. These include Initial Public Offerings (IPO), private placements, venture capital funding and crowdfunding.
Strategies for Raising Capital
Capital raising is primarily of three types, as described below:
-
Financing Debt
Debt financing means you must pay the principal amount and a fixed interest you agreed on back to the lender.
Third parties pay the fund or the capital in debt finance. Such lenders include banks, bond markets, financial institutions, and private equity funds. While raising debt means access to fast cash at a low-interest rate, it also entails a decrease in the credit ratings of an organisation.
Debt repayment does not depend on the company’s business performance. Hence, the debt must be repaid even if a business is not performing well.
-
Financing Equity
The second most common way to raise capital is through equity financing. Equity financing is raising funds by selling equity or a share in the company's ownership.
The investors can be anyone with the funds available to them to meet the valuation of the stocks set by the company or its owners. The stock market is the most crucial method for raising equity. The company must not, however, overvalue its equity, or it will lose prospected investors.
The most significant advantage of equity financing is that no interest repayment is required, making it a much less risky approach than debt financing. However, it also means giving up a portion of your control over the business and consulting the investors or shareholders before making significant decisions.
-
Hybrid Financing
Hybrid financing, as the name suggests, is a combination of debt and equity financing. A hybrid financing solution is a lot more flexible as it provides both the company and the investors with a lower-risk option. It also ensures access to a broader range of investors.
The negative side of hybrid financing is that it is more complex and often gives investors an upper hand over the company's expenses.
Conclusion
Optimising capital structure and implementing effective capital raising strategies are critical for businesses aiming to achieve sustainable growth and maximise shareholder value. Striking the right balance between financial flexibility and fiscal discipline, aligning capital structure with business strategy, and employing various optimisation strategies can help companies navigate the complex landscape of capital management. An investment banker can help with this.
Enrol in Imarticus’s Certification in Investment Banking Operations programme to learn the fundamentals of financial markets, trade life cycle, risk management and regulations. This investment banking course has a job-focused curriculum and offers dedicated career services for candidates seeking a career in investment banking.
