business finance capital

business finance capital

The Role of Capital in Business Finance

1. Introduction to Capital in Business Finance

Topics that we will cover related to capital in business finance include: issuance of bonds, settlement of sales, and retirement of bonds; finance (capital) charges and increments in capitalized cost; issuance of common capital, settlement of sales, reacquisition of common capital, and payment of dividends; corporate distributions; capitalizing earnings; issue and retirement of cumulative preference shares and preferred dividends; conversion of participation share certificates, and retirements of participation share certificates.

The Chartered Financial Analyst (CFA) program and Study Session 16 introduces the concepts that influence both the firm’s capital structure decisions—the relative mix of debt and equity in the firm’s financing—and the use of each external source of funds for the firm.

Capital is the fundamental underlying requirement of any enterprise, and it can be obtained in two forms—debt and equity. Debt is associated with a transaction in which one individual acquires resources from another individual or commercial institution in exchange for a promise to make a payment in the future. Equity is associated with a transaction in which one individual acquires resources in exchange for a proportionate ownership interest in the corporation.

2. Types of Capital

Typically, debt capital carries with it a fixed or regular return. The payment is fixed by contract, in the case of secured debt by the contract itself, and in the case of unsecured debt by applicable lending practices. Law and custom, including bankruptcy and liquidation procedures, provide a secure creditor with a closer-in if a borrower defaults. Equity capital, on the other hand, carries no specific obligation to pay returns. It is a variable return as the corporation grows and prospers over the years. It is important to realize that bankruptcy has a different meaning for the stockholders of the form, because their investment is the residual investment in the corporation; they will receive the remaining assets only upon the liquidation or dissolution of the business.

There are two main types of capital: (1) equity, consisting of the firm’s stock and owner’s equity, and (2) debt, consisting of long-term loans, other long-term obligations including long-term lease obligations, and short-term obligations, such as short-term bank loans and commercial paper. These form the sources from which a company can obtain the money it needs in order to commence, continue, or expand operations. In return for the use of these funds, the firm agrees to pay a return to the providers. This return may take the form of periodic interest payments to the debt holders and, in the case of equity, divided payments plus capital gains to the stockholders. It should be noted that stockholders are residual owners, which means that in the case of liquidation of the form or in the case of a bankruptcy of the firm, the stockholders will receive what is left after all other claims are satisfied.

3. Capital Structure and Financial Decision Making

But we expect business financial managers to behave in a different manner when we turn our attention to the managerial problems of the firm. We expect them to be concerned with all costs. In particular, we expect them to be concerned with costs that are directly associated with specific aspects of financial decision making. Two categories of costs stand out in this regard. One is the incremental corporate income tax that is imposed on the firm as it faces a positive or negative corporate tax liability. The other is the possibility of bankruptcy that a firm may face when the market value of its obligations exceeds the market value of its assets.

In the last two sections, we simplified the real world by assuming away corporate taxes and bankruptcy costs that greatly concern business financial managers. This section deals with incorporating these costs explicitly in the choice of a corporation’s capital structure. This topic is important, both for the implications that these costs have for capital structure and for the effects these implications have on the capital structure that is actually observed in the real world. We illustrate the former, that is, how changing the structure that is actually observed in the real world. This assumption is used regularly in economic analysis, including that in the preceding section and is useful for determining what the direction of change is once all costs are accounted for.

4. The Importance of Capital in Business Growth

In a modern U.S. economy, private industry will generate substantially all of the thirty to forty billion dollars of capital growth needed annually in order to increase, outside the government area, the tax base by six or seven percentage points. It is that tax base, not government-supported projects themselves, which holds the inherent strength and vitality of the competitive economy, and which brings the still unmatched performance of free enterprisers in the allocation of resources. In an era of specialized technologies, specialized manpower, specialized ideas and specialized capital, what businesses manage to do is still crucial to the strength of the nation. With millions of independent decisions by high caliber individuals, businesses generate approximately 45 to 50 per cent of the U.S. gross national product. They also contribute to the U.S. capital base, and hence to the U.S. growth capital scarcity in a direct manner. Its ability to compete is therefore crucial.

In the relatively near future we may face shortages of well over $100 billion a year, annual charges, including taxes, to have even the same gross capabilities in 1975 (including a substantial increase in public facilities structure) that we have enjoyed in 1969. These are figures of dimensions which adjust cannot be dismissed as lacking in significance no matter how hard we would like to wish them away. In fact, of course, it is the interrelationship of other efforts which add strength to the U.S. economy in competition that also provide the key to solving the problem. Capital matters, then, both in raw magnitude of resources committed and in effective use of those resources. Uncoordinated growth through arbitrary smoothing of demand by fiscal and monetary policy forces simply serves to magnify the capital scarcity by generating a needed new capital investment, or drawing an adequate supply of new capital equities. Moreover, it creates current account deficits which reduce the capital base still further. The basic elements of national tax and expenditure policy add, of course, to industrial decisions on reinvestment and financial contracts. But the overall magnetism and differentiation of labor still have their origins in industrial and business and human resource policies.

Special efforts are required to prevent an overemphasis on new financial tools, which are merely symbols of business growth, from drawing attention away from the real requirements for sustained progress, build-up of the capital structures of an expanding American economy. A capital shortage cannot be corrected by gimmicks. It can only be corrected by moving capital and financial resource commitments, and thus economic power, back into an appropriate balance with requirements for a growing economy. The competitive strength of the economy today is dependent as never before on the gross level of capability, including both tangible and human elements, which the economy can bring to bear, in combination and in a coordinated way, against competing efforts and resources from other parts of the world. Broad experience in the national, business, and financial world leads clearly and incontrovertibly to the conclusion that capital scarcity restricts growth of such capabilities at the same time that management disciplines have improved. In opposing the concept of unrestricted growth, which often leads to inefficient use of resources and constricting of the economy in the long run, we are aware that situations temporarily exist in some industries where inadequate capital constraints are restricting efficiency, and with it the competitive posture of the entire industry in both domestic and foreign markets.

5. Conclusion and Future Trends

Changes in the financial system have created opportunities and threats to small firms. The advances in information technology increased the reach of financial systems. The techniques used for the evaluation of project’s risks are now so advanced that the financial systems are starting to be able to create financial services, customized to the clients’ specific needs, that do not require collateral. Still, small firms are too risky for the existing financial system. But, since finance is a key factor in the success of these firms, the international community and the State must provide the necessary conditions. These are improving the business environment, the support to entrepreneurship and small business’s growth, the promotion of alternative financial institutions and the enforcement of prudential regulation in the financial system.

Small enterprises play a significant role in the world’s economy; they contribute to social equity, sustainable economic growth, development and poverty alleviation. A major obstacle to small firm’s contribution to the social economy and poverty reduction is the lack of access to finance due to the characteristics of these firms: they are young, riskier and with imperfect accounting standards, and because they often have no tangible assets that can work as guarantees. The existing financial systems do not offer small firm the financial services they need.