The funds used to manage the day-to-day operations of a business are known as working capital.
The old adage that you have to have money to make money is especially true in the area of capital raising. Various sources of business capital include sales 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 stock. To reduce the cost of capital, finance managers often choose the fundraising methods that cost the company the least.
The total cost of capital of a company is usually calculated as a weighted average cost of capital.
The methods that cost less depend on the individual circumstances of the company. For example, a finance manager might determine that selling stock would be the cheapest way to make money, but the company has not done an initial public offering, or IPO, of stock, so selling to common stockholders is not an option. In this case, the company can sell more products or raise other types of investment funds, whichever is more likely to reduce the cost of capital.
The funds used to manage 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 an entrepreneur in a corporation or LLC decides to use his own money as working capital, his money will be 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 an ongoing stable financial appearance. The costs of raising shares include IPO advertising and obtaining a financial institution to facilitate the sale of shares. To reduce the cost of capital, companies can lower the amount of dividend payments, but this can have the negative effect of lower share prices.
The total cost of capital of a company is usually 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 more weight added to sources that provide a proportionately larger amount of money. This calculation doubles the company’s required rate of return, or how much it must earn to provide working capital, pay off debt and pay dividends. Debt financing is often the most expensive form of capital and can be used to meet a required rate of return, but it is generally not an efficient way to reduce the cost of capital.