Profit, Capital & Competition in the U.S. Economy

Instructor: James Walsh

M.B.A. Veteran Business and Economics teacher at a number of community colleges and in the for profit sector.

Businesses have three primary ways to raise capital, which are related to their ability to make profits. The competition a business faces will also affect its profits. This lesson will explore the relationship of capital, competition, and profits.

The Need for Capital

Well, the big day has finally arrived. Becky is going to take the plunge and open her new bakery! She loves to bake, but that isn't her only reason. Like many people, Becky loves the idea of being her own boss. Like all business owners, however, she needed to raise capital before she could open the doors. Capital is the financial value of assets that raise revenue. Her ovens, counters, tables and chairs are capital goods, and she needed financial capital (money) to pay for them. Her parents were willing to lend her some money, and they aren't too particular about when they get paid back. But she needed more.

Opening the bakery requires capital.
Baked Goods

Raising Capital with Debt

Small businesses like Becky's have three primary ways of raising financial capital when they need it. The first is through debt, which is just borrowing money and paying it back with interest. Debt financing for small businesses is done by banks. Banks like to lend money based on collateral. If Becky borrows to buy ovens or other fixtures they will want to put a lien on them. They might also ask Becky's parents to cosign or put a lien on their personal property, like a second mortgage on their home.

The bank is also going to want to see Becky's business plan. The loan officer will determine whether Becky has a believable plan to make a profit, since she will need to do so in order to pay back the loan. Profits are the revenue left over after all of the bakery's costs are paid. The size of Becky's loan will depend on how much profit the bank believes she can make.

Big corporations can skip the bank and raise capital by issuing bonds. The investors who buy bonds are in effect lending money to the corporation. When the electric company in Becky's town needed to build a new power plant, they issued tens of millions of dollars' worth of bonds to investors in the financial markets. Investors who buy the bonds will want to see the electric company's financial statements to assure themselves that the utility will make enough profits to pay the bond principal back along with interest.

Raising Capital with Equity

The second way to raise capital is through equity or ownership. Becky's uncle was willing to lend her some cash. Uncle Joe had eaten Becky's baked treats before and he was convinced she would be a big success. But instead of being repaid with interest, he wanted to own 20% of the business as an equity stake. Uncle Joe explained that this means he will be getting 20% of any profits that Becky makes. They would be partners, and since Uncle Joe knows a lot about business, Becky knew she was getting a partner who can really help her. They made the deal!

Big corporations use equity financing to raise large amounts of capital by issuing stock. The investors who buy the shares are just like Uncle Joe; they become part-owners of the company and have a claim to a percentage of its profits. Investors buy stock in a company because they believe it will make profits now and in the future.

Self-Financing Capital Needs

Becky and Uncle Joe are expecting big profits too, which means they will be able to raise capital in the future by self-financing. Instead of keeping the profits from the bakery for their own personal use, they can put them back into the business. Uncle Joe suggested that he would be willing to put some of his share of the profits back into the business and Becky wants to do the same. She hopes that if she wants to expand or needs additional equipment, she will be able to draw on accumulated profits. That will sure be better than dealing with the bank, or giving away more of her business to an equity investor!

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