How Cost of Capital Financing Techniques Affect the Organization
In the medium and long term, how a company's owners and management choose to invest the company's capital drives both company strategy and its future competitiveness. In the short term, a company's capital budgeting decisions impact available cash and how it accesses cash. Part of this decision involves the cost of capital and the impact of that cost and its related financing techniques on the organization.
Cost of capital refers to the cost or opportunity cost of making a particular investment. The cost of capital is the rate of return a company could have earned by putting the same money into an equally risky but different investment. Put another way, it is the rate of return the company requires to make a specific investment. The driving belief is that companies choose the investment that provides the higher return, given two investments of equal risk. Cost of capital depends on how a company uses funds, not how it sources its funds.
Companies with good profits and strong operating cash flow can finance expansion internally. Businesses can use a healthy operating cash flow to fund marketing and sales initiatives, open new offices or hire additional personnel. Companies determine the cost of using this operating capital by comparing the return of the projects it invests in or the impact of the people it hires on the bottom line. The other option would be to return the cash to owners through distributions or hold and invest the cash in marketable securities; therefore, companies can also determine the cost of capital by comparison to these options.
The corporation is the primary legal structure that businesses use to raise money, because it facilitates the sale of shares of stock to raise equity for the business. Limited liability partnerships can sell partnership interests, and limited liability companies can sell membership interests to raise money. Companies with little internal cash and tight operating and profit margins or a limited operating history may have equity as their only option. Issuing equity provides cash for the founders to invest but reduces their ownership percentage. So owners must determine if the company’s projects will generate high enough returns to make up for the dilution.
Debt financing entails borrowing money. Companies that use debt financing to fund projects take on loans or similar financing obligations. Companies must pay back the principal amount borrowed along with interest. Businesses can deduct the interest on the debt as an operating expense. Debt increases the rate of return, but it also increases financial risk, which is the risk the company will fail because it cannot meet its repayment and interest obligations. Companies must compare the cost of the debt to the returns generated by the projects it invests in.