Week 7, Fadhil's Blog #4 - Capital Structure, Giving Our Business or Owing Money? Maybe Both.

Hey everyone, I hope you had a great weekend because I did! Back with me again Fadhil as all we know, in today's blog Im going to talk about capital structure which basically means how a business/organisation fund their operations. This week topic is quite important and interesting especially for me personally due to the fact that I wanted to become an entrepreneur which meaning I will create my own business. Since creating a business is not easy and require lots of money, there are many ways for us to fund our business plan that includes debt and equity issues. However, source will always be needed by the business and the costs would be the offering, since we all know that in the financial world the profit or return of investment is always uncertain for investors. What is cost of capital or COC, According to HBR (2015), cost of capital can be defined as the amount of return that the funders of a business expect by providing the capital. 

Usually, the most common types of funders or investors that provide funds for a business projects are Stock Purchasing (Equity Capital) and Loan Issuing (Debt Capital). Well, the question is how will the company will manage and calculate their capital costs? It's quite obvious as I think their financial experts will do the calculation for the company such as the returns for the investors. From that, the decision can be conclude as by financial results, managements can predict and decide if its worth the take. There are formulas to calculate the cost of debt and the cost of equity. Usually, Weighted Average Cost Capital (WACC) can also be use to measure debt and equity capital

Two types of funding gives different requirements and risks, normally, the cost of capital is lower compared to the required rate of return. I believe that in order to be safe, high rate of return should be required. It also comes back to the company itself when deciding the size of required return and cost of capital since they are the one who can measure it. For example, if I own a company and the cost of capital is 7% I may give a higher discount of rate to 10%. Back again, It all depends on the risk of company.

Most of the time, more popular and better rate company usually get easier when it comes to funding their business. My question is that, what will companies choose, equity or debt financing and how do they choose it? It again depends on the company sizes and purposes, usually bigger companies choose both of them with balance amount from both as balancing the source of money could increase total profit margin. The most popular example of major business funding is a streaming music company called Spotify, as all we know from the year it was founded until now, the business need to expand in order to beat the competitors such as Apple music and more streaming firms. In order to that, it requires huge amount of money which in 2016 the company raised $1 billion of its debt financing in order to expand the business internationally. The decision by Spotify to rise its debt rather than equity is a questionable decision as it may not be the best option for the expansion.  

Spotify funding type is categorise as convertible debt which means the debts invested by those corporates will be converted to Spotify's equity after liquidity event. thus, Spotify need issue its debt and not equity if the share price increase significantly. This might be one of the reasons why Spotify raised its debts. But in my opinion, I think the reason why Spotify wants to raised such a high debt is because it increased the company's today share price. There are other possible reasons why Spotify raised its debt financing. As Spotify's investors, TPG, Goldman Sachs, and Dragoneer will definitely want the safer investment that able to return their investments. Even though in my opinion the risks that Spotify took for the expansion is not that risky and still moderate, by purchasing convertible bonds the investors might still be able to receive their required money back in the unlikely event of project failure, while if it choose to buy more stock will resulting loss. Basically, Spotify is convincing its funder that their investment is not that risky and safe as the project is clear and achievable for the company to do. 

As a conclusion, based from Spotify example, the business is successfully increased their revenue growth in 2017 and going to better direction although currently the numbers of profit is not very pleasent. So why does company choose convertible debts financing? I guess it really attracts the investors due to its risk and security, there is a faith of share price increase and lower borrowing costs.