How to Minimize the Cost of Capital

How to minimize your cost of capital

 

Every business needs capital.  Choices businesses make in financing business decisions is a critical factor in profitability.  Businesses need to focus on current financing sources and balance sheet structure to minimize the cost of capital. 

 

 

  • Focus on reducing working capital needed to run business.  As accounts receivable and inventory turn to cash, this capital is available for other projects or debt reduction.  The effective “cost” of this capital is 0%. 

 

    • Utilize technology to speed up collection of receivables
      • Bill customers electronically
      • Receive payment electronically
      • Research Customer Initiated Payments, a new form of on-line invoice posting and payments
      • Analyze the cost of  a lock box service

 

    • Challenge vendors and evaluate manufacturing process to minimize inventory levels while maintaining ability to satisfy customer requirements.

 

    • Employ a cash management system to obtain maximum benefit from idle cash.

 

  • Prudent use of traditional bank debt.

 

    • Match short-term needs with floating rate bank lines and utilize cash management services to minimize borrowings. Current cost of capital for short—term borrowing needs range from 4%-6%, and this rate is further reduced by the tax deductibility of the interest expense.

 

    • Take advantage of current interest rates to lock-in permanent financing for equipment, real estate, and other long term needs.  Consider refinancing existing debt if the interest rate savings warrant the time and expense of refinancing. Current cost of capital for longer term borrowings range from 5%-8% (depending on length of term and risk parameters), and this rate is further reduced by the tax deductibility of the interest expense.

 

 

  • If needed, utilize nontraditional funding sources.

 

    • If your business needs a significant amount of working capital, more aggressive advance rates are available from collateral based lenders.  The interest rate is generally higher than bank debt, and the cost of the capital is increased by monitoring fees, resulting in an all-in cost ranging from 10-13%, less tax savings.

 

    • Another source of capital is a blend of equity and debt finance known as mezzanine finance.  These investors generally structure facilities with a “cash-pay” interest rate of 10-12%, plus a share in the ownership of the business, increasing expected returns to 18-20% (the interest component is tax deductible).

 

    • The most expensive source of capital is equity.  Although this capital source is the most expensive (in excess of 20% for most private equity sponsors), using equity instead of debt greatly reduces the risk associated with required debt service payments.

 

Prudent use of leverage can greatly enhance returns to shareholders, particularly with current interest rates (depending on your industry and confidence in future years’ performance). 

 

Have your CPA, banker or other advisor advise your business on the optimal capital structure to minimize cost of capital.  Good financial management cannot help a bad company, but bad financial management can hurt a good company. 

 

Bank of St. Petersburg is headquartered in Tampa, Florida and operates in both Pinellas and Hillsborough counties.

 

About the authors:

 

Stephen B. Stagg is a senior vice president with Bank of St. Petersburg, a locally owned independent community bank headquartered in Tampa focused on the banking needs of local businesses and professionals.  A University of Florida graduate with a degree in Finance, Steve earned his MBA degree, with distinction, from the University of Pennsylvania’s Wharton School, where he was a Palmer Scholar.  Steve has over 10 years of financial services experience, including private banking with Bank of America and corporate and investment banking experience Wachovia.

 

Edmund O’Carroll  is a senior vice president with Bank of St. Petersburg.  He is a Certified Treasury Professional (CTP) and a member of the Association for Financial Professionals.  Edmund has over 11 years of financial services experience primarily as a middle market commercial banker with Bank of America.

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