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How to Reduce the Cost of Capital

Essay by   •  September 27, 2012  •  Essay  •  942 Words (4 Pages)  •  1,826 Views

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Cost of capital is associated with the expected rate of return and risk. High risk could increase the cost of capital. Therefore, measures to reduce risk in business will help enterprises to have the lower cost of capital and attract capital from more different sources.

From the point of view of the capital investors, the future income of business is evaluated to be high and stable, and the risk level is lower if enterprise has large-scale, long-term operating history, high transparency level, reasonable capital structure, capable management team, effectiveness of the work, etc. In addition, there is a reverse relationship between the liquidity of stocks with the cost of capital of the enterprise. As liquidity increases, the cost of capital can be reduced.

There are some solution and strategies which enterprises can apply to decrease the cost of capital.

a. Attract investors by stock split:

Stock split is a decision of a company to increase the number of shares by breaking them up. As the result, the value of each share also varies. However, the market capitalization value of company shall remain the same, similar to when a person have 100 USD now, and he changes it to two 50 USD banknotes. There are various ways to split shares. One share can be divided to two shares (2 for 1 stock split), to 3 shares (3 for 1 stock split) or two shares are divided to three shares (3 for 2 stock splits).The easiest way to determine the value of new shares is divided the price of original shares to the splitting ratio. In the example above, we get 100 USD divided by the splitting ratio of two, and the new price is 50 USD. If the splitting ratio is two shares to three shares, the new stock price is 33.3 USD.

The first reason is due to investor's psychology. When the price of a stock tends to keep up, some investors are afraid because the price is too high; another some small investors want to buy but they are not capable. Stock split makes the stock price drops (corresponding to the splitting ratio) to a price that seems more "attractive" than the original one. No doubt, this effect is purely psychological. The true value of the shares did not change, but after stock split, a lower stock price could attract many new investors, especially small ones. Splitting the stock also gives existing shareholders the feeling that they suddenly have more shares than before and of course, if the stock price rises, they have more shares to sell.

Another reasonable cause is that the stock split can increase shares' liquidity. When the value of shares touches a high price (hundreds or thousands USD), the selling and purchasing margin is quite large. For example, in a period, Berkshire Hathaway's stocks have been trading at nearly 100,000 USD per share and the margin can be up to more than 1,000 USD. By stock splitting, selling and purchasing margin thus can be reduced, thereby greater liquidity of stocks can be generated and cost of capital can be reduced.

b. Selling and purchasing securities

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