Every great business utilizes arbitrage and leverage. They do it in many different ways, but to have a big impact on the world, these forces must be involved. The classic example is borrowing money at a low cost in order to put it to work at a higher cost. This is in itself is the business of banking.
Arbitrage is also the way in which almost every great business was able to grow rapidly from a smaller business into a larger business. Another method large corporations use is to “go public” and raise capital at no cost to the corporation (although at a significant dilution cost to the current owners) through the selling of stock.
Although the previous owners are diluted, the resulting company, flush with capital and in the hands of capable leadership, might be able to grow the company at many times the rate it would have been able to without the new capital.
Think about it….Would Bill Gates be the richest man in the world if he kept all the ownership of Microsoft to himself and didn’t take on the capital available through the stock market? No, the company might not have succeeded at all without doing this! But by raising low cost funds in this way, a world dominating software company has evolved and massive amounts of wealth have been built.
For large public companies, when the opportunity is there for explosive growth, sometimes it’s wise for capital to be raised in the equity markets in this way, and in other scenarios, it makes more sense to use the debt markets which have a fixed cost.
For the smaller business, the debt markets are usually the only option to achieve this kind of capital leverage. By borrowing at a low rate and putting the new capital to work at a higher rate, a strong capital manager will be able to reap much larger profits than he would have been able to without the leverage.
Arbitrage involves accessing capital at one rate and putting it to work at a higher rate. Ask yourself, in what way is the investment I’m looking at taking advantage of this principle?
This is Part 17 in the series Investment Due Diligence. To use this as a growth tool to better understand your own calling, you might start by reading Part 1, Pt 2, Pt 3, Pt 4, Pt 5, Pt 6, Pt 7, Pt 8, Pt 9, Pt 10 , Pt 11, Pt 12, Pt 13, Pt 14, Pt 15, and Pt 16.