Question

Recommend Several ways a corporation can reduce their borrowing costs to gain a competitive advantage over a rival

Answer 1

There are several ways in which the corporate can reduce its overall cost of capital that is weighted average cost of capital

Cost of equity

The equity shareholders expect certain level of return vis a vis the risk they are taking by investing in the stock and business of the company. The investors do not demand any security for their investment and are ready to be a partner in profits and losses. They have put their faith on the business model of the company and therefore no security is taken by them. The riskier the company’s business model, the higher would be the equity shareholders return expectations. The risk perception can be changed in the minds of the investor by altering the risk profile of the project to suit equity holders.

Cost of debt

The interest rate paid by the company on the loans availed from financial institutions or the debentures raised by it are called cost of debt. The debt investors would require security for putting money into the company’s debt. The interest rate is determined by the risk the company has due to nonpayment or defaults. The interest on debt is tax deductible and therefore cheaper than the equity capital. The debt can be issued with the option of call feature built into it to call back the debt when the yields have fallen. Alternative sources of debt should be analysed to check if a better deal is available or not. If it’s possible to avail a better deal the company should avail the revised debt and pay off the current debt. Also the company can issue bonds with the interest payments that match the cash flows of the business.

Capital restructuring exercise

The company can change the capital structure to lower the cost of capital by substituting the debt capital for equity capital in required proportions. Usually the firms follow the leaders in the industry to get the guidance for the capital structure. Higher use of debt should be done with caution as it’s a fixed commitment over the tenure of the debt. The effective proportion of short term debt and long term debt has to be maintained to achieve a proper balance.

A company can obtain a better competitive advantage over rival by following the above steps and always try to optimize the cost of capital. The savings in the cost of capital is actually net addition to the bottom line. The credit records of the company should be always kept in a good shape to command a better rate then the competitor.