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The Principles of Capital Funding Planning

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The principles of capital funding planning

Introduction

Capital funding planning is concerned with sources of finance or funds, in particular those comprising the capital structure. While there is probably an optimal capital structure or mix of debt (loans, debentures) and equity (ordinary shares and reserves), it is certainly no easy matter to achieve it or, indeed, determine what it is. It is possible to list the factors which ought to receive consideration but assessing the weightings remains very largely a matter of judgment and experience. There are five factors that must be considered by a company planning how to raise money or finance for subsequent investment in assets to generate income. They are cost,acceptability,risk,control and transferability.

Discussion

Cost

The cost of capital is of considerable importance to a business. It is used to determine the viability of projects which are then undertaken or not. If these projects are medium to long-term and involve large amounts of capital investment, then it is imperative that this decision-making criterion is calculated as precisely as possible. Furthermore, it will be in the interests of the business that the cost is kept to a minimum because more projects are then viable and risks are reduced.

Current and future costs of each potential source of finance should be determined or estimated, and a comparison made. Sources are not necessarily independent of each other as, for example, an increase in debt now may require an increase in equity later to maintain the balance. Businesses will normally seek to minimise the weighted average cost of capital.

Acceptability and Risk

Finance can only be raised if investors are willing to invest. Capital structure must be acceptable to investing individuals and institutions. Although the company may find it advantageous to issue debt capital,the investor or financial institution provider is disadvantaged-low return with no share of tax advantage and the investment itself suffers from inflation. There can,therefore,be a certain resistance to debentures in favour of the'growth'investment in ordinary shares. There are two compromises for people to reconcile a company which wishes to raise finance by way of debentures and investing public which is willing to give that finance but,preferably,in the form of ordinary shares. Firstly, alter the rates of return so that debenture holders receive a higher rate of return than ordinary shareholders. Secondly, a convertible issue.

Allied to acceptability is risk. It is undesirable to have to cut or omit a dividend. Also there may be dangers in being unable to meet interest and/or other charges. Profit levels and gearing require consideration. Investors and investing institutions

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