Whether a company is big or small, at some stage it will have to raise capital to expand its operations, take on new projects or employ more staff. It is important to understand these concepts not only when you are the company needing to raise capital, but also if you have the capital needed as it can possibly be a good investment. There are two ways that companies can raise capital or ways in which investors can invest in companies, namely via debt or via equity. Let us consider each of these types of capital and how they will work.
Debt capital is also referred to as debt financing. Funding by means of debt capital happens when a company borrows money and agrees to pay it back to the lender at a later date. The most common types of debt capital used by companies are loans and bonds.
A company looking to raise capital through debt may need to approach a bank for a loan, where the bank becomes the lender, and the company becomes the debtor. In exchange for the loan, the bank will charge interest, which will be presented on the company’s financial statements, along with the loan. The company justifies the cost of the loan by ensuring that it can grow and therefore make more profit from using the capital it borrowed.
Another option the company has is to issue corporate bonds. These bonds are sold to investors and mature after a certain date. At maturity the principal amount that was loaned is paid back to the bond holder. Before reaching maturity, the company is responsible for paying the bond holder interest payments. These payments can either be paid on a few predetermined times throughout the lifetime of the bond or they can be lumped together and paid along with the principal amount at maturity. The interest that is paid to bond holders are referred to as coupons and the return they get on the investment via the coupons is known as the yield. The principal amount is often also referred to as the face value of the bond or the par value which is the rand value of the bond when it is issued and the amount the investor will receive again at maturity.
A coupon rate is simply the total value of coupons received in a year divided by the face value of the bond. If a bond pays R100 each six months, the total amount of coupons that the company will pay during that year is R200. Let us assume the face value of the coupon is R1500, then we can calculate the coupon rate as follow:
R200 / R1500 x 100 = 13.33%
Coupon rates need to be compared to the interest rate that can be earned at a bank for an investor to decide if the investment is worth making.
Bonds can however also be traded in the secondary market after they have been issued. In the secondary market the bond can be sold for either more or less than the face value. The price of the bond in the secondary market will affect the yield of the bond and this new yield is referred to as the Yield to Maturity (YTM). The YTM is calculated by considering how many coupons the bond will still pay as well as the additional or lesser face value that the investor will earn at maturity. When bonds are being sold for less than the face value it means that the investor will receive a higher amount for what he invested now, at maturity, meaning their YTM increase. Investors say that the bond is trading at a discount if the market price is less than the face value. When the face value is however less than the bond price in the secondary market, it is trading at a premium. This means an investor will pay more to hold a bond than they will receive at maturity for the bond and as such the YTM will decrease.
There are different factors that influence the price of the bond in the secondary market and the main factor is the market interest rate paid by banks. If interest rates increase, bond prices will decrease and thus YTM will increase. This happens because the investor needs to be incentivised to rather hold the bond than just put their money in a bank and earn higher interest there. If market interest rates fall, the price of the bond will increase and as such the YTM will be lowered. This will happen because the investor would rather want to hold a bond that pays a higher coupon rate compared to the interest the investor can receive by depositing money in a bank.
Another important factor that plays into the market price of bonds at maturity is the risk the investor is exposed to by holding a bond. One of the risks is that the issuer of the bond (the company that raises capital by issuing shares) defaults and can’t pay back the principal amount or the coupons. If a company has a higher risk of default, they need to make it more attractive for investors to invest in them by offering higher coupons. In the secondary market the market price will be lower compared to other companies with lower risk, to incentivise investors to buy the bond as the YTM will be higher at the lower market price.
Equity capital is generated through the sale of shares of company stock rather than through borrowing. If taking on more debt is not financially viable, a company can raise capital by selling additional shares. These can be either common shares or preferred shares.
Common (ordinary) shares give shareholders voting rights but don’t really give them much else in terms of importance. They are at the bottom of the ladder, meaning their ownership isn’t prioritized as other shareholders are. If the company fails or liquidates, other creditors and shareholders are paid first.
Preference shares are unique in that payment of a specified dividend is guaranteed before any such payments are made on common (ordinary) shares. In exchange, preference shareholders have limited ownership rights and have no voting rights.
The next article will look at how public shares are issued in the primary and secondary market.