Allocating Capital Efficiently
Every step of the way on the capital life cycle, different decisions will have to be made by the company’s management.
Step 1: Type of capital used to finance the company’s assets
Management needs to determine the mix of debt and equity capital to use. Using debt financing increases the capital available to the company beyond the equity holders’ contributions and accumulated profits and reserves. On the flipside, taking on debt means that the company would need to ensure its cash flow is sufficient to meet scheduled payments of interest and principal, and adhere to debt covenants, among other considerations.
In this step, the management needs to decide what is the optimal capital structure of the company. The CFO would have to weigh the relative costs of debt and equity (for example by WACC), in order to determine how much debt capital and/or equity capital has to be raised.
Referring to diagram 1 above, the point marked by the red lines represent the optimal capital structure – where WACC is at its lowest. This is the theoretical point where the cost of capital is at its lowest.
To the left where debt levels are low, it is inefficient because the company is financing with the equity, which is more expensive than debt. So they could afford to lower the overall cost of capital by leveraging up.
To the right, where debt levels are high, it is also inefficient. As company is becoming more leveraged, it becomes riskier, and hence the cost of debt starts to pick up. Therefore, they should delever by reducing debt or increase equity into the company.