Grab Holdings (NASDAQ: GRAB) recently announced that it would be raising cash through a convertible note offering. This came as a surprise to investors as Grab still has lots of cash on its balance sheet.

But if you look at recent history, it is not uncommon to see companies raise cash when the cost of capital is relatively low, even when they have sufficient cash on their balance sheets.

Companies such as Zoom Communications (NASDAQ: ZM) and Tesla (NASDAQ: TSL) raised cash through a secondary offering in 2021 when their stock prices went hyperbolic. 

With stock prices rising to new all-time highs again, we could potentially see more companies taking advantage of favourable market conditions to raise cheap capital. With that in mind, I thought it would be a good time to share some quick thoughts on such capital raises.

Understanding cost of capital

The question of whether a company should raise capital boils down to whether the returns earned on the capital exceed the cost of capital.

But there is a lot of confusion over what the cost of capital is. For debt issuance, the cost of capital is simply the interest that is paid on the debt. For equity issuance, the cost of capital is a lot more complicated.

There are a few schools of thought when it comes to calculating an equity’s cost of capital. I like to keep things simple – and the simplest way to think about it is by assessing the impact on future returns to shareholders on a per share basis. For instance, if a company needs to issue 300 shares and has 1,000 shares outstanding, the cost of capital is 30% of the company. To make the share issuance worthwhile, the company needs to ensure that the money raised will be able to increase the future stream of cash returned to shareholders by at least 30%.

So a company that is projected to return $1 per share to shareholders for eternity will require the cash that is raised to increase that return-figure to at least $1.30 to justify a share issuance that dilutes shareholders by 30%.

Does Grab’s issuance make sense?

With this in mind, let’s take a look at Grab’s recent note offering. Last month, Grab announced that it would be raising US$1.5 billion through a zero coupon convertible note offering. 

Convertible note offerings are debt offerings in the sense that the money needs to be paid back. But because it is convertible, these notes can potentially be turned into equity. In Grab’s convertible note offering, the debt can be turned into equity if its stock price trades above the conversion price of US$6.55. If the conversion happens, Grab does not need to pay back cash to the note holders but the new shares will become dilutive to existing shareholders.

Let’s assume that all these notes will be turned into equity. As of end-2024, Grab had a fully diluted share count of 4.3 billion shares (including warrants, unvested restricted stock units, and options). The note offering, if converted to shares, will result in 229 million new shares being created, which means 5.3% dilution. In other words, for the convertible note offering to make sense for Grab, it needs to use the proceeds to increase its future cash returned to shareholders by at least 5.3% per share. 

This can be done in two ways: (1) Grow the cash generated by the company by more than 5.3% or (2) decrease the share count by more than 5.03% (a 5.03% reduction in share count will lead to 5.3% per share growth – you can do the math)

Grab mentioned that it could potentially use the cash to buyback shares. If they manage to do it at the current share price of around US$4.70, the company will be able to buy back 330 million shares or around 7.3% of its fully diluted share count (this includes the 5.3% dilution from the conversion of the convertible notes). This would be a massive win for the company. In essence, Grab would be able to reduce its share count even after the conversion of the convertible notes to shares, simply by using the cash raised and buying back its shares at current prices.

Grab doing a massive buyback may not be far fetched, as the company also simultaneously announced along with its note offering that it is buying back around US$273.5 million of its shares at US$4.68 each from buyers of the notes.

Bottom line

As investors, it is challenging to assess whether equity raises make sense or not. The theory mentioned above may be simple but in most cases, there are many moving parts.

Cash is also fungible, and we usually do not know where the capital went. If the company had not raised cash, which aspect of its expenses or investments would it have cut?

As an investor, instead of trying to assess where the money went, one thing that we can do is to dissect whether management teams are raising capital at opportune times; opportune times are when stock prices are high or when interest rates are low. This is when the cost of capital is the cheapest. Likewise, companies should be buying back stock when stock prices are low and holding back on debt issues when interest rates are high.

As investors, owning a strong business is one thing, but we also need management teams that are savvy with capital allocation and capital raising. Management teams that can make use of opportune pricing of stocks and debt can greatly increase the returns of shareholders.

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Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently have a vested interest in Tesla Inc. Holdings are subject to change at any time.