Question:
If a company wishes to invest in new equipment as technology demands, should they not to the capital markets to raise those funds? Is it moral to have their customers to pay for such equipment by raising customer fees & rates. By having customers pay for the cost of new capital equipment, it allows the companies shares to rise in value, which enriches share holders. Is this the way the business world operates ?Answer:
You ask, “Is it moral to have their customers pay” by raising prices? Well, let’s ask it this way. Assuming the quality of the product increases because of the investment in the new technology, are customers willing to pay higher prices after the investment? If the answer is yes, then, sure, it’s moral. The customers got a higher quality product. If customers didn’t pay for the product when the prices went up, then the firm goes out of business, and shareholders are not happy.
Allow me to quibble a bit with the question, though. Customers buy products, they don’t buy the company’s assets. I like Taco Bell, but no matter how many tacos I buy, I have no claim on the restaurant. New equipment and technology are assets. Assets have only two claimants on them: owners (equity holders) and lenders (debt holders). Hence the fundamental accounting identity is
Assets = Debt + Equity.
(Aside: Can you bring customers into the accounting identity? Yes, customers can buy stock and become equity investors or they can buy a company’s bonds and become lenders.)
Setting aside for the moment whether a company can even raise its prices (you might want to read an earlier post about market power), think about it this way…if a company really can raise prices to cover the costs of the new asset, then it is paying for the asset by diverting money from the owners into the asset. You are diverting the owners’ dividends into retained earnings. Wait, what? Yep. Look at the accounting identity again. If you retain profit to buy a new factory or a truck or a robot, then that asset is bought by…the owner. It becomes part of the company and the owner has a claim on it. Customers don’t.
Companies have only two choices for capital financing: Ask the owners to finance it (Equity) or ask a lender to finance it (Debt). The morally-okay-socially-optimal-benefit-to-everyone-including-the-customer way to finance that, by the way, is to make that financing trade-off as low as possible (it’s one of those “minimum-of-the-average-cost-curve-things”).
There is, in fact, a formula for this.
The optimal level of substitution between debt (lender’s share) and equity (owner’s share) for any capital expenditure is at the lowest point of a company’s weighted average cost of capital, measured as an interest rate called, unsurprisingly, WACC.
WACC = i(1-t)(D/A)+r(E/A)
where i= rate the lender offers for the financing, t=tax rate (because taxes on loans are deductible); D= the amount of debt the company has, A is the amount of assets the company has, and r is the return that the owners want on their equity investment, E. A firm’s choice then is how much D and E to use in financing the new technology while keeping WACC as small as possible. Keep WACC low and the firm won’t pass along higher prices to its customers any more than needed to cover the costs. Hopefully customers will enjoy the new features and reward the firm’s asset investment by buying the new and improved good.
