Question

Firms that minimize their cost of capital will maximize their value (assuming all other factors are held constant). Thus, managers spend a lot of time considering how their cost of capital might be reduced. Give a strategy that a firm could follow to reduce their cost of capital, and how it might be employed.

Answer 1

If the firm is not optimally levered i.e., underlevered , the firm can increase the proportion of debt in capital structure. Debt is cheaper and also interest payments are tax deductible making it much cheaper than other sources of capital.

Assuming the firm is already optimally levered or overlevered, a firm might reduce the cost of capital by reducing the cost of common stock, debt and preferred stock. The cost can be reduced by decreasing the risk of the firm. Risk can de decreased through two ways-reducing Business risk (going for consolidation or diversification of businesses, reducing fixed costs, technological upgrades etc.). Financial risk can be reduced by decreasing the presence of debt in the capital structure beyond a certain point.