A fair number of companies know how to calculate the cost of capital, and have done so at some point in the past. However, how frequently do they recalculate the cost of capital, and (especially) do they ever discuss the ways in which it can be reduced? This is a particular problem for debt-heavy companies who have more than the optimal debt levels. For these organizations, the primary concern is that the next dollar of debt will become increasingly difficult to obtain, requiring an incremental cost of capital that could be sky-high.
Even for those companies with more moderate debt levels, it is certainly worthwhile to regularly strategize over how the corporate cost of capital can be reduced, since even a decline of a few basis points drops straight into net profits.
Shrinking the cost of capital usually requires one of two approaches: either obtain guarantees that will allow lenders to reduce their rates, or free up enough cash to pay off higher-cost debt. Obtaining guarantees is a difficult proposition, and will require the cooperation of either a wealthy individual or a corporate parent. However, improving cash flow is a more viable alternative for nearly everyone. Here are some possible ways to do so:
- Review the capital spending plan to determine which planned purchases do not involve increases in the capacity of bottleneck operations, and eliminate them if they do not.
- Aggressively pursue early payment discounts for a few large-dollar customer accounts in order to squeeze more funds out of accounts receivable.
- Sort the inventory records by turnover for each item, and research the reasons why low-turnover items are still in stock. Chances are good that some policy changes are needed regarding buying in excessively large quantities, implementing engineering change orders before raw material stocks have been exhausted, and having production runs longer than what are actually needed by customers.
These approaches are useful for locating cash within working capital, which can be used to draw down debt balances and thereby shrink the cost of capital.