The Financing Decision: How That Capital Is Raised

The financing decision is how a company pays for the capital it uses. Sankalp Industrial Systems Limited, an invented manufacturer, is funded 75.0 per cent by equity and 25.0 per cent by debt at market values, being Rs 18,00,00,00,000 of market capitalisation against Rs 6,00,00,00,000 of gross debt. The mix is not free. Each source has a price, and the blend of those prices is what every rupee the company invests must beat.

Start with a scooter. The awkward part of this subject lands faster on something small. A household wants one and the showroom wants Rs 1,00,000. The household has Rs 40,000 saved and borrows the other Rs 60,000. Two entirely different arrangements have just been made on the same morning, and almost nobody notices that they are different in kind rather than in size.

The Rs 40,000 of savings carries no date and no amount. Nobody will knock on the door in April asking for it. The Rs 60,000 carries both: a fixed instalment, on a fixed day of every month, whether the scooter is being used or is standing under a tarpaulin with a broken clutch. The household did not simply raise Rs 1,00,000; it raised Rs 60,000 of promise and Rs 40,000 of patience, and the two behave differently on every day that follows.

The scooter morning is the whole of the financing decision. Only the scale changes: the borrower is a manufacturer rather than two rooms behind a main road, and every figure below can be checked line by line.

What is actually being decided here, and what is left to somebody else?

A company doing anything at all needs capital: machines, a building, the stock sitting in the stores, the money owed by customers who have not paid yet. Two separate questions sit underneath that. Where should the capital go, and where should the capital come from. The second of those two is the financing decision.

The two questions are genuinely separable. The separation is not obvious, and it is the reason this subject can be taught at all. Whether the third valve line is worth building is a question about valves, customers and machines. Who paid for it is a question about contracts. The line produces the same castings whichever way the money arrived. The financing decision does not touch the operations; it settles who has a claim on what the business produces, and on what terms.

Sankalp Industrial Systems Limited is a listedIts shares are bought and sold on a public exchange, so a price for them can be observed on any trading day rather than estimated. manufacturer of industrial valves, precision castings, and the spare parts and service that go with them. Every figure below belongs to it, and each is stated where it is used rather than assumed from anywhere else.

What are the two sources, and what is the one difference that matters?

Money can be raised in a great many named forms, and a reader who goes looking will find dozens of them. Underneath the names there are two, and they are separated by a single structural difference from which everything else follows.

Debt is a promise. A stated amount, on a stated date, whatever else is happening. The lender's claim does not improve in a good year and does not shrink in a bad one. Equity is a residual. There is no stated amount and no stated date; the owner receives whatever is left after everybody with a stated amount has been paid, whenever there happens to be any.

The fixed claim against the leftover claim is the difference, and it is the only structural one. Ask why lenders are paid before owners, and the answer is that a fixed claim has to rank ahead of a leftover one or the word leftover means nothing. Ask why the two are priced differently, and the answer is the same. Ask why one of them tightens a company in a bad year while the other quietly absorbs it, and the answer is the same again.

If the promise is the cheaper source, what is the company giving up for it?

A promise is worth more to the person holding it than a hope is, so it is bought more cheaply. The certainty in the promise explains why borrowing costs a company less than equity does, at Sankalp and at almost every company anybody will ever look at. The lender knows the amount and knows the day; the owner knows neither. Being certain of less is worth paying for.

Here is the part that gets skipped. The reason the promise is cheap is the reason it is dangerous, and those are not two facts. The cheapness and the danger are one fact read from either end. The lender's certainty is manufactured out of the company's obligation; there is nowhere else it could come from. Every rupee of comfort on the lender's side of the contract is a rupee of rigidity on the company's side.

And the obligation is wider than the interest. A borrowing arrangement typically carries a set of covenantsPromises about conduct written into a loan document, such as keeping a ratio above a stated level or seeking consent before selling an asset. What they contain and what happens when one is broken are settled elsewhere. alongside the rate: things the company agrees to keep doing, and things it agrees not to do, for as long as the money is outstanding. The covenants constrain the company on days when nothing has gone wrong at all.

So the price of debt has three parts, and the rate is only the first of them: the coupon, the date, and whatever the company has agreed not to do while the money is outstanding. A financing decision taken on the rate alone has priced one of the three and has assumed the other two away.

What is this company's mix, and what are the two numbers behind it?

Sankalp Industrial Systems Limited has 20,00,00,000 shares outstandingThe count of shares actually in issue and held by somebody, which is the number any per-share figure is divided by. and an observed price of Rs 90.00 each. Multiply the two and the whole equity claim comes to Rs 18,00,00,00,000. Its gross debt is Rs 6,00,00,00,000. Add them and the total capital is Rs 24,00,00,00,000.

Three quarters of this company is funded by people with no promise at all, and one quarter by people holding one. Both figures matter and neither is idle: they are the weights that decide how much of the company's overall cost of funding is set by the price of each source.

Why is the mix measured at what the market would pay, not at what the accounts record?

The accounts do carry an equity figure for this company. Its book value of equity is Rs 9,00,00,00,000, being what shareholders originally contributed plus everything the business has retained since, less everything paid out. The book value is a perfectly good number and it answers a perfectly good question: how did the equity claim come to be the size it is.

The book figure answers the wrong question here. A weight in a funding mix is being asked what it would cost to retire that claim today. Retiring the equity would mean buying out 20,00,00,000 shares at what somebody will actually sell them for. At the observed Rs 90.00 that comes to Rs 18,00,00,00,000. The Rs 9,00,00,00,000 is history. The weights ask what the claims would cost to buy out now, and only the market figures answer that question.

The difference is not cosmetic. Measured against the book figure the same Rs 6,00,00,00,000 of borrowing is a 40.0 per cent share of a Rs 15,00,00,00,000 total, rather than the 25.0 per cent it is at market. The company has not borrowed a rupee more. Only the denominator moved, and it moved by nearly two thirds.

What does the borrowing cost, when it is three separate contracts?

Nobody arranges a company's entire borrowing in one transaction, and Sankalp did not. Its Rs 6,00,00,00,000 is three contracts, signed at three different times, for three different purposes, each with its own rate, its own charging frequencyHow often interest is calculated and applied: monthly, quarterly or half-yearly. It changes what a quoted rate actually amounts to over a year, and that arithmetic is settled elsewhere. and its own repayment date.

To get from three rates to one, weight each rate by how much is actually borrowed on it. Rs 3,00,00,00,000 at 7.80 per cent costs Rs 23,40,00,000 a year. Rs 2,00,00,00,000 at 8.50 per cent costs Rs 17,00,00,000. Rs 1,00,00,00,000 at 7.60 per cent costs Rs 7,60,00,000. The three bills add to Rs 48,00,00,000, and Rs 48,00,00,000 on Rs 6,00,00,00,000 of borrowing is 8.00 per cent exactly.

Averaging the three rates instead gives 7.9667 per cent. The gap is a third of a basis point short of nothing, and the method is still wrong. A simple average treats a Rs 1,00,00,00,000 facility as though it carried the same weight as a Rs 3,00,00,00,000 loan. Here the smallest borrowing happens to carry the cheapest rate, so the simple average flatters the answer; on a different set of contracts the same mistake would run the other way and by more.

The rates blend and the dates do not. There is no such thing as an average repayment date. The Rs 3,00,00,00,000 falls due at the end of Year 5 whatever the other two contracts say, and no amount of weighting makes that day arrive differently.

Why does that 8.00 per cent behave like 6.00 per cent?

The tax bill is struck after the interest has already been taken off. Nothing of the kind happens to a dividend. The gap between the two treatments is purely mechanical, a matter of where each payment sits relative to the tax line, and it changes what borrowing actually costs.

Take Year 1. Interest of Rs 48,00,00,000 reduces the profit the tax is computed on by Rs 48,00,00,000. At the 25.0 per cent effective tax rate assumed for Sankalp throughout, and assumed rather than read off any statute, the tax bill is Rs 12,00,00,000 smaller than it would otherwise have been. So the Rs 48,00,00,000 of interest costs the company Rs 36,00,00,000 net.

Run it as a rate rather than as rupees and the same thing appears: 8.00 per cent times 0.75 is 6.00 per cent, exactly. The company pays 8.00 per cent to the lenders and bears 6.00 per cent, and the difference is not a discount anybody granted but a consequence of where interest sits in the arithmetic. Money paid out to shareholders comes out of profit that has already been taxed, so nothing equivalent happens to it.

What does the other source cost, and why does no line in the accounts show it?

The profit and loss account of any company shows the interest. The equivalent line for the shareholders is not there at all. The absence is not an oversight in the format; it is the direct consequence of equity being a residual. A cost that cannot be stated in advance cannot be charged in advance.

The cost is nonetheless entirely real. The people holding those 20,00,00,000 shares parted with money they could have put somewhere else, and they parted with it on the understanding of getting something for the wait and something for the uncertainty. If the business does not deliver that, they have made a loss in the only sense that matters, even in a year where the reported profit was positive and the dividend was paid.

Equity costs more than debt at this company, and the reason is the same difference the whole argument turns on: the owner is being asked to accept an uncertain, last-in-line claim, and nobody accepts that for the price of a certain one. The size of that cost, how it is estimated from observable things, and what each of its inputs does are built up in detail under the cost of equity.

What happens once both prices sit in one number?

Two sources, two prices, two weights. Combined, they give one number for what the whole of the funding costs. At this company that number works out at 12.00 per cent, taken as given here and built input by input under the cost of capital.

The number matters because of what it is used for. Every rupee this company puts into anything, a new valve line, a warehouse, an extra month of stock, is funded by that mix and therefore carries that price. So the 12.00 per cent is the line a proposed use of capital has to clear. Aswath Damodaran's material makes this the hinge of the whole subject: the mix does not merely describe how a company is funded, it sets the hurdle that everything the company does is judged against.

The 12.00 per cent is why the financing decision is not a back-office matter: it decides the number the investment decision is measured with. A company that funds itself differently is not simply a company with different lenders. The company is judging its own opportunities against a different line.

Is this decided once, or decided again every year?

Very few companies raise all their capital once and stop. Sankalp does not. Across its forecast, every one of five successive years adds another Rs 1,00,00,00,000 to the capital already in the ground, and a quarter of each addition is borrowed. A quarter of Rs 1,00,00,00,000 is Rs 25,00,00,000, so gross debt climbs by Rs 25,00,00,000 annually for five years.

The working capital facility is the contract built to be drawn downMoney actually taken from a facility that has been arranged. An arranged facility can sit unused; only what is drawn is borrowed and only what is drawn carries interest. on, so the whole of that increase lands there. So the facility stands at Rs 2,25,00,00,000 once Year 5 closes, against the Rs 1,00,00,00,000 it began with. The term loan and the debentures sit exactly where they were. Gross debt across the three contracts reaches Rs 7,25,00,00,000.

The interest column runs on the opening balance of each year at the blended 8.00 per cent. So Year 1 charges Rs 48,00,00,000 on the Rs 6,00,00,00,000 the company started with, and Year 5 charges Rs 56,00,00,000 on the Rs 7,00,00,00,000 it started that year with. The financing decision is not an event at incorporation; it is taken again every time the business wants to grow faster than its own cash allows.

Notice also that the shape of the borrowing is drifting while nobody redecides anything. Five years of drawing on one facility has quietly changed what proportion of the company's debt is short-dated and renewable, and that happened as a consequence of a rule rather than as a decision anybody took in Year 3.

Why is the repayment date part of the price?

Go back to the table of three contracts and read the last column instead of the rate column. The term loan is repayable on a single day at the close of Year 5. Not a bit each year. The entire Rs 3,00,00,00,000, all at once.

By the time that day arrives the company owes Rs 7,25,00,00,000 in total, so the instalment is 41.38 per cent of everything outstanding. Set it against what the business actually produces that year. Free cash flow to the firm is Rs 1,70,00,00,000, and a year of cash generation covers 56.67 per cent of the payment. The 56.67 per cent is before a rupee has gone anywhere else: not to the other lenders, not to capital expenditure, not to shareholders.

The rate on that loan is 7.80 per cent and the date on it is a separate charge that never appears in any rate. Two loans of the same size at exactly the same coupon, one repaid evenly and one repaid in a single instalment, do not cost the same thing, and no comparison of rates will ever show it.

The shape of the promise is what costs, not how any one company handled it. The responses available to a company facing such a date, and when it has to start arranging them, are worked through in detail under refinancing.

Two things are worth taking off that control. The first is the shape. The interest sits in the denominator, so cover does not fall in a straight line; it falls as a reciprocal. So the early rupees of borrowing move cover a great deal in absolute terms and the later ones move it less: the fourth readout makes that visible, falling from 1.67 times at Rs 2,00,00,00,000 of borrowing to 0.20 times at Rs 6,00,00,00,000 and to about 0.05 times at Rs 12,00,00,00,000.

The second is what that shape means for reading the number. A cover ratio that has stopped moving much is not a sign of safety; it is a sign of the flat part of a curve, where each further rupee of borrowing does less to a ratio that is already low. The measure gets quieter exactly where the position gets tighter, and a schedule read alongside it catches what the ratio on its own no longer shows.

What does the financing decision not change?

The valves. The castings. The customers who buy the spares. Everything the business actually does with the capital, and therefore everything the capital actually earns.

The cash the operations generate is struck before any of the funding arithmetic reaches it, and at this company the increase is the same size in each successive year.

Not one rupee in that column was set by who lent what. The column was set by revenue, by margin, by depreciation, by what the company spends on plant and by what it ties up in stock and in money owed by customers.

Underneath the operating line sits a different question entirely: who has a claim on that cash, in what order, and at what price. The claim, the order and the price are the whole of the financing decision. Koller, Goedhart and Wessels build their entire treatment of value on keeping those two things apart, and the reason is practical rather than tidy. Held still, the operating side lets the effect of a funding choice show on its own; mixed together, the two make it impossible to tell whether a result came from the business or from the way it was paid for.

The question left standing

The financing decision, the two sources, how the mix is measured, what each source costs, the fact that the decision recurs, and the fact that a date is a price: all of that now stands. One question has been raised and left standing throughout: is 25.0 per cent the right share of debt for this company?

No block above answers that, and none of them should be read as having quietly answered it. The 25.0 per cent is simply what Sankalp's borrowing happens to be at Year 0, worked out from a share price and three loan contracts. Whether a different share would leave the company better off is a question about how the cost of each source behaves as the mix moves, and that is a considerably larger piece of arithmetic than anything here.

Reading a company's funding closely enough to say what it consists of, what it costs and when it falls due is the whole of what has to be in place before that question can be asked properly. The other half of the pair, where the capital should go once it has been raised, is the investment decision.