Businesses can raise capital through various sources, including selling products and services, borrowing, debt leverage, and investment money. Financial managers choose the least expensive method to lower the cost of capital, which can include selling shares, owner financing, or reducing dividend payments. The total cost of capital is calculated as a weighted average cost of capital, which doubles as the company’s required rate of return. Debt financing is usually not an efficient way to reduce the cost of capital.
The old saying that one must have money to make money is especially true in the area of capital raising. Various sources of business capital include the sale of products and services, borrowing, and debt leverage. Investment money is another source of capital, and investment dollars can come directly from an investor or from the sale of shares. To lower the cost of capital, financial managers typically choose methods of raising funds that cost the company the least.
The methods that cost less depend on the individual circumstances of the business. For example, a financial manager may determine that selling shares would be the least expensive way to make money, but the company has not had an initial public offering, or IPO, of shares, so selling to common shareholders is not an option. In this case, the company could sell more products or raise other types of investment funds, whichever is more likely to lower the cost of capital.
The funds used to run the day-to-day operations of a business are known as working capital. Corporations and limited liability companies, or LLCs, are treated as individual entities, financially and legally separate from the owners and shareholders. This means that if a business owner of a corporation or LLC decides to use his own money as working capital, his money is treated like any other investment fund. Owner financing is a quick and easy way to reduce the cost of capital, as long as the owner can afford it.
Stock sales are like large-scale owner financing, with hundreds of owners buying shares and investing relatively small amounts of capital. This can be a virtually unlimited source of capital, as long as the company keeps shareholders happy by paying good dividends and appearing financially stable. The costs of raising stocks include IPO advertising and securing a financial institution to facilitate the sale of stocks. To lower the cost of capital, companies can reduce the amount of dividend payments, but this could have the negative effect of lower share prices.
A company’s total cost of capital is often calculated as a weighted average cost of capital. The phrase “weighted average” means the after-tax cost of each funding source, added together, and then averaged with greater weight added to sources that provide a proportionately greater amount of money. This calculation doubles as the company’s required rate of return, or how much it must make to provide working capital, pay off debt, and deliver dividends. Debt financing is often the most expensive form of capital, and can be used to meet the required rate of return, but it is not usually an efficient way to reduce the cost of capital.
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