1. Weighted Average Cost of Capital
So let's discuss conceptually the weighted average cost of capital, or the
WACC. It's essentially the proportion of debt and equity a firm has,
multiplied through by their respective costs. So let's bring in a diagram
with the cost of equity and the cost of debt.
We can think about the cost of equity as the rate of return
a shareholder would require in order to invest equity into a business.
And similarly, the cost of debt would be the rate of return that
a lender would require given the risk of the business.
So one thing that we've started to discuss is that the optimal capital
structure of a firm is defined as the proportion of debt and equity
that results in the lowest weighted average cost of capital, or WACC, for
the firm. So now let's get into a little bit more detail with
a WACC formula. We have a diagram here, in a mix of debt
and equity. We could calculate the percentage of net debt and the percentage
of equity. In order to get the WACC, we would then multiply those
percentages through by the cost of debt and the cost of equity.
What this would give us is the relative contribution from each of these
sources of capital. If we then add those sources of contribution,
we get the overall cost of capital or the WACC. So let's go
deeper to look at an example with numbers applied now. We have 14%
debt and 86% equity. If we bring in the cost of debt at
3.5% and the cost of equity at 9%
we can multiply these through to get 0.5%
and 7.7% respectively. Once we add those two figures together, we get the
weighted average cost of capital for the firm at 8.2%.
Now that we've gone through a calculation, let's hop into Excel and look
at a real example and see how this weighted average cost of capital
gets applied into decision making.
2. Let's practice!