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    Corporate Cost of Capital

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    What can a corporation do to lower its' cost of capital?

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    What can a corporation do to lower its' cost of capital?
    The cost of capital is the required rate of return that a firm must achieve in order to cover the cost of generating funds in the marketplace. Another way to think of the cost of capital is as the opportunity cost of funds, since this represents the opportunity cost for investing in assets with the same risk as the firm. When investors are shopping for places in which to invest their funds, they have an opportunity cost. The firm, given its riskiness, must strive to earn the investor's opportunity cost. If the firm does not achieve the return investors expect (i.e. the investor's opportunity cost), investors will not invest in the firm's debt and equity. As a result, the firm's value (both their debt and equity) will decline.

    Factors which go in determining right mix:

    The Nature of Agency Cost of Debt

    The agency cost of debt is associated with monitoring, enforcing, credibly promising, and constraining decisions, and result from the general situation in which the optimization problem for one constituency is suboptimal for another constituency. In terms of the agency costs of debt, Jensen and Meckling (1976) suggest that the potential conflict between equity and debt claimants is presented primarily in terms of wealth expropriation and risk shifting.

    Shareholders may capture wealth from bondholders by investing in new projects that are riskier than those presently held in the firm's portfolio. If the projects perform well, shareholders capture most of the gains, while ...

    Solution Summary

    The solution discusses tactics a corporation can take to lower its capital.