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The old saying that one must have money to make money is especially true in the area of raising capital. Various sources of business capital include selling products and services, incurring debt, and debt leverage. Investment money is another source of capital, and investment dollars can come straight from an investor or from the sale of stock. To reduce cost of capital, financial managers typically choose the methods of raising funds that cost the least to the company.
Methods that cost less are contingent on the individual circumstances of the company. For example, a financial manger may determine that selling stock would be least expensive way to make money — but the company hasn’t had an initial public offering, or IPO, of stock — so selling to common shareholders isn’t an option. In this case, the company might sell more products or raise other kinds of investment funds, whichever is more likely to reduce cost of capital.
Funds used to run a company’s day-to-day operations 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 as any other investment funds. Owner funding is a quick and easy way to reduce cost of capital, as long as the owner can afford it.
Sales of stock are like large-scale owner funding, with hundreds of owners buying stock and investing relatively small amounts of capital. This can be a virtually limitless source of capital, as long as the company keeps shareholders happy by paying good dividends and consistently appearing financially stable. Costs of raising stock include IPO publicity and securing a financial institution to facilitate the sale of stock. To reduce cost of capital, businesses may lower the amount in dividend payments, but this could have the negative effect of lowered stock 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 every source of funding, added together, and then averaged with more weight added to sources that provide a proportionally higher 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 back debts, and offer dividends. Debt financing is often the costliest form of capital, and may be used to meet a required rate of return, but isn’t usually an efficient way to reduce cost of capital.
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