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Corporate Finance Fundamentals: Raising Money—Debt, Equity, and the Cost of Capital

Capítulo 6

Estimated reading time: 7 minutes

How Companies Raise Money: The Main Funding Sources

Companies finance day-to-day operations and long-term growth by combining several funding sources. The mix matters because each source comes with different obligations, risks, and strategic trade-offs.

1) Retained Earnings (Internal Funding)

Retained earnings are profits kept in the business rather than paid out to shareholders. They are often the first choice because they avoid new contracts with lenders or new owners.

Best for: steady reinvestment (new hires, software, incremental capacity, marketing tests).
Constraint: limited by profitability and timing (you can’t retain what you haven’t earned yet).
Hidden cost: shareholders still expect a return; using retained earnings is not “free.”

2) Bank Loans (Private Debt)

A bank loan provides cash today in exchange for scheduled interest and principal payments. Loans can be short-term (working capital) or long-term (equipment, facilities, acquisitions).

Key features: fixed or floating interest rate, maturity date, collateral, and covenants.
Covenants are rules (e.g., maintain a minimum interest coverage ratio) that protect the lender and can restrict management choices.
Best for: predictable cash flows and assets that can serve as collateral.

3) Bonds (Public Debt)

A bond is debt sold to many investors, typically in larger amounts than bank loans. The company promises periodic interest payments (coupons) and repayment of principal at maturity.

Key features: coupon rate, maturity, credit rating, and bond covenants.
Trade-off: can be cheaper and longer-term than bank loans for strong issuers, but requires market access, disclosure, and ongoing investor relations.
Best for: larger companies with stable performance and the ability to issue at scale.

4) Equity Issuance (New Shares)

Equity financing raises money by selling ownership stakes (shares). Equity does not require fixed payments like interest, but it changes who owns the company and who controls decisions.

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Forms: public offering, private placement, venture capital, strategic investors.
Best for: high-growth opportunities where cash flows are uncertain and flexibility is valuable.
Cost: investors expect higher returns because equity is riskier than debt (equity holders are paid after lenders).

Debt vs. Equity: A Practical Comparison

Companies rarely choose “all debt” or “all equity.” They choose a mix based on cash flow stability, control preferences, taxes, and flexibility.

Criteria	Debt (Loans/Bonds)	Equity (New Shares)
Cash flow obligations	Requires contractual interest and principal payments; missing payments can trigger default.	No required payments; dividends are optional (unless preferred stock terms require them).
Control dilution	No ownership dilution; lenders may impose covenants and monitoring.	Dilutes existing owners; new shareholders gain voting rights and influence.
Tax effects	Interest is typically tax-deductible, reducing effective cost (a “tax shield”).	Dividends are generally not tax-deductible; equity returns come from dividends and price appreciation.
Financial flexibility	Too much debt reduces flexibility due to fixed payments and covenant limits; refinancing risk exists.	More flexible in downturns (no mandatory payments), but issuing equity can be expensive and may signal weakness if done at low valuations.
Risk to the company	Higher financial risk as leverage rises; greater bankruptcy risk in bad years.	Lower bankruptcy risk; investors absorb more downside through valuation declines.
Typical use case	Funding assets with predictable cash flows; optimizing taxes; mature businesses.	Funding growth, R&D, expansion into uncertain markets; early-stage or high-growth firms.

Rule-of-Thumb Decision Logic

If cash flows are stable and predictable: debt becomes more feasible because the company can reliably meet payments.
If cash flows are volatile or growth requires flexibility: equity (or less debt) reduces the chance that fixed obligations force cutbacks at the worst time.
If maintaining control is critical: management may prefer debt or retained earnings over issuing new shares.
If the company already has high leverage: additional debt may be costly due to higher perceived default risk and tighter covenants.

Cost of Capital: The Company’s “Hurdle Rate”

The cost of capital is the return the company must earn on its investments to satisfy its capital providers (lenders and shareholders). It acts like a hurdle rate:

If a project is expected to earn more than the cost of capital, it tends to create value (it compensates providers for risk).
If a project is expected to earn less than the cost of capital, it tends to destroy value (it underpays for risk).

Because companies use both debt and equity, a common summary measure is the weighted average cost of capital (WACC). WACC blends the after-tax cost of debt and the cost of equity in proportion to how much of each the company uses.

Why WACC Moves

Business risk changes: entering riskier markets or launching uncertain products can raise the cost of equity.
Leverage changes: more debt can lower WACC at first (tax shield) but can raise it later if default risk increases.
Interest rates and credit spreads change: debt becomes cheaper or more expensive depending on market conditions and company credit quality.
Equity valuation changes: issuing equity when the stock price is low is effectively more expensive (more dilution per dollar raised).

Step-by-Step Example: Estimating a Simplified WACC

This example uses a simplified approach suitable for planning and quick comparisons. In practice, companies refine these inputs, but the structure is the same.

Given Inputs

Market value of equity (E): $600 million
Market value of debt (D): $400 million
Cost of equity (Re): 12%
Pre-tax cost of debt (Rd): 6%
Corporate tax rate (T): 25%

Step 1: Compute Total Capital and Weights

Total capital is the market value of debt plus equity:

V = D + E = 400 + 600 = 1,000 (million)

Weights:

Weight of equity (We) = E / V = 600 / 1,000 = 0.60 (60%)  Weight of debt (Wd)   = D / V = 400 / 1,000 = 0.40 (40%)

Step 2: Convert Cost of Debt to After-Tax Cost

Because interest expense is typically tax-deductible, the effective cost of debt is reduced by the tax rate:

After-tax Rd = Rd × (1 − T) = 6% × (1 − 0.25) = 6% × 0.75 = 4.5%

Step 3: Calculate WACC

Simplified WACC formula:

WACC = (We × Re) + (Wd × Rd × (1 − T))

Plug in the numbers:

WACC = (0.60 × 12%) + (0.40 × 4.5%)  WACC = 7.2% + 1.8% = 9.0%

Estimated WACC = 9.0%

Step 4: Interpret What This Means for Investment Decisions

With a WACC of 9.0%, the company should generally look for investments expected to earn returns above ~9% (with comparable risk). This does not mean every project must beat 9% mechanically; it means the company’s overall investment program must clear that hurdle to avoid value erosion.

What a Higher vs. Lower WACC Implies for Strategy

Higher WACC (e.g., 11% instead of 9%): capital is “more expensive.” Fewer projects clear the hurdle, so strategy often shifts toward (a) higher-margin initiatives, (b) faster payback, (c) reducing risk, (d) improving operating efficiency, or (e) strengthening the balance sheet to reduce financing costs.
Lower WACC (e.g., 7% instead of 9%): capital is “cheaper.” More long-term projects can justify investment, enabling (a) capacity expansion, (b) longer-horizon R&D, (c) acquisitions, or (d) pricing/market-share plays—provided returns still exceed the hurdle.

Quick Sensitivity Check (Practical Planning)

Small changes in inputs can move WACC meaningfully. For example, if the company’s credit risk rises and Rd increases from 6% to 8% (tax rate unchanged), after-tax debt cost becomes 6%. Then:

WACC = (0.60 × 12%) + (0.40 × 6%) = 7.2% + 2.4% = 9.6%

That 0.6 percentage point increase can cause marginal projects to fall below the hurdle, changing which initiatives get funded.

Putting Financing Choices and WACC Together

Financing decisions affect WACC, and WACC affects which investments make sense. A practical way to connect them is to ask:

Funding fit: Does the project generate stable cash flows that can safely support debt payments?
Control and timing: Is management willing to dilute ownership now, or is debt/retained earnings preferable?
Flexibility needs: Could a downturn force painful cuts if the company adds fixed obligations?
Hurdle impact: Will the chosen financing mix raise or lower WACC, and does the project still clear the hurdle after that change?

Now answer the exercise about the content:

A company is deciding how to finance a new project with uncertain cash flows and a strong need for flexibility during downturns. Which financing choice best matches these conditions?

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Equity is often better when cash flows are volatile because it has no required interest or principal payments. This preserves flexibility in downturns, though it dilutes ownership and investors expect higher returns.