Capital allocation is about deploying cash. And in the first few lessons, we talked about cash generated and deployed from operations and investments. In this lesson, we will talk about some of the considerations of cash raised from debt and equity. debt financing is always going to be your cheapest source of financing. However, it comes with a catch, you must pay it back and abide by the rules of the lending arrangement. equity financing on the other hand is always going to be the most expensive source of financing.

From a liquidity standpoint, however, there is no associated hooks to consider. But don't be misled into thinking that there's no cost to this financing, yet better believe your shareholders have an expectation of return. If you master capital allocation, your shareholders will put your stock on a pedestal and reward you with higher multiples, which affords you have the opportunity to use your stock like a currency piss your shareholders off though You can cut off an important means of sourcing capital. So the key is to find ways to leverage debt without jeopardizing the company. Many organizations find themselves operating at the extremes either too much debt or too much equity. Too much debt creates a house of cards, the slightest downturn collapses the deck.

Also, running your business with consistently high levels of debt impedes your ability to capitalize on large opportunities that may present themselves at a moment's notice. On the other hand, having too much equity drives down shareholder returns and shareholders will penalize you by dropping your multiple by treating these assets. Often excess cash has redundant assets and non operating assets. One generates a multiple The other is worth some percentage of its liquidation value. The same way in which patients must be exercised in purchasing businesses only when the price is right. This same sort of patience is necessary for your finances.

Strategy. In general, issuing equity is going to be your last resort. Why? Because it dilutes your existing shareholders and they hate it. The only time you should consider issuing equity is when your stock is trading at a premium to the intrinsic value of the stock. Sometimes equity gets issued to recapitalize a business that finds itself over levered.

And this is often the kiss of death for your existing shareholders. You never want to put yourself in a position where you need to do this. If you are a long term Citigroup shareholder prior to 2007. You know exactly what I mean. Citigroup diluted 90% of the value of all of its long term shareholders in the wake of the financial crisis by issuing shares to maintain its liquidity, which has only been marginally better than the outcome of some of its peers that did not survive at all. The issuance of new shares through an underwriter will cost you at a minimum of 5% of the proceeds raised the out of pocket costs.

For legals and accounting, we'll also make issuing equity very penalizing to both the company and your existing shareholders. So this is the least preferred method of raising funds. A slightly better method of issuing equity is to use your equity has a currency to acquire new businesses through a private placement or a vendor can take back consideration. This avoids the underwriting issuance costs and preserves cash on hand to use for other allocation purposes. The secret to this strategy is to issue stock that is more highly valued on a multiple basis than the business acquire. So for example, if you're a CEO of a public company trading it's a target Ziva, and you're acquiring a business at three times EBITDA.

There should be immediate accretion to all shareholders split between the old and the new as the market digest the deal and essentially revalue the business acquired from three times to eight times. But what is even better is if you can use debt to make this acquisition Obviously, you can't be stupid about over leveraging your balance sheet. But the more debt you can use the more value that attributes to your existing shareholders. Imagine your existing shareholders getting the full of creative benefits of acquiring a business for three times. But having a valued in the public markets and eight times less whatever interest expense you occur on the debt. Master capital allocators will make this bet, but only if it temporarily over leverages their balance sheet.

They will only take on the higher degree of financial leverage. If they know they can aggressively pay down the debt to right size the leverage and reload the balance sheet again for the next deal. That, my friends is how supersize shareholder returns are generated. Master capital allocators don't think of their balance sheet in terms of an ideal or optimal capital structure or annual filing dates. They think in terms of economic cycles, which may be several years at a time. They build up liquidity when times are And they invest like crazy when valuations become no brainers.

How contrarian indeed, In this lesson, we covered three important points. First, issuing equity for cash is a last resort. Second, using equity as a currency can be an effective acquisition tool for the master capital allocator. And third, don't be afraid of debt, but don't fall in love with it either. Ensure you always have capital available to make a deal. In the next lesson, we will look at what to do with our surplus cash to tell them