Weighted Average cost of capital pmtycoon What is WACC? WACC Basics Why do we need WACC? Where is WACC used? Debt Types of Capital Preferred Stock Equity WACC WACC Breakdown Cost of Capital for Debt Cost of Capital Cost of Capital for Preferred stock Weighted Average Cost of Capital for Equity W=weight R=cost WACC Formula WACC Application in Real World WACC = wdrd (1-t) + wprp + wede P=preferred stock Capital Budgeting Techniques E=equity Baselined Minimum Returns T= tax % of the firm Investment Decisions Overview of your learning from this video • What is WACC, why is it needed and Where is it used? • Breakdown of WACC • Weighted Average • Types of Capital • Equity • Preferred Stock • Debt • Cost of Capital • Cost of equity • Cost of Preferred Stock • Cost of Debt • WACC Formula Explained • Application of WACC formula in Capital Budgeting • Finally, Congratulations to you, YOU have become more smarter after watching this video! , I bet!, but how do you know, unless you watch it? • Comments: If you have not. And I will hand hold you to make you smart :) What is WACC, why is it needed and Where is it used? • What is WACC ? • Everything in life has a cost. Do you agree? • Example: Cost of maintaining a relationship : Time spend with them (or sometimes buying gifts ) • Similarly, everything you do in business has a cost. • Example: Pay interest of loans, Pay employee salaries, Marketing expenses etc. etc. etc. • Business needs capital (to setup, to grow, to build products, to run operations, and for a zillion other things) • The capital that is invested in a business also has a cost (after who gives free money now a days ) • Example of a Company: Share holders needs dividends, Banks needs interests, etc. etc. these are some of the costs that you incur on Capital. We will delve deep but for now, getting a base understanding is important. • So, coming to the what part: What is WACC: WACC is nothing but trying to figuring out the cost of the capital that is invested in our business. What is WACC, why is it needed and Where is it used? • What is WACC ? • But wait, isn’t WACC stands for Weighted average cost of capital. • Yes it does, : What I have cleared so far is cost of capital. • Let me talk about weighted average. What the heck is weighted average? • For that I may have to use an example: Otherwise how do you remember it without forgetting. Teaching is one challenge and making sure you are not forgetting is other challenge! . • I have a basket of Fruits, in which I have 10 apples and 4 Oranges, Each apple costed me $4 dollars (Heck apples are always costly) and Oranges costed me $2 dollars each. (After all fruits are sold costly for finance professionals like us ) • So we are saying my basket has 10 apples and cost of each apple is $4 dollars and 4 Oranges and cost of each orange is $2 dollars. • Now, I will ask you to pause for few seconds and tell me what is the Average cost of all the fruits in my basket. If any one watching this video is going to say, it is $3 dollars then think I’m banging my head against a wall. • The answer is this : • First sum: (10 Apples X $4) + (4 Oranges X $2) and divide the result ($48 in this case) by Total no.of fruits (14) and the Average cost of each fruit is $48/14 = $3.43 dollars. • OR I can also use percentages and do the same. Like Total fruits are 14 in basket and Apples share is 10/14 and Oranges share is 4/14. There fore Apples Percentage is 71.43% and Oranges percentage is 28.57% • I can do the above problem using percentages as (71.43%X$4) +(28.57%X$2) = $3.43 dollars • So, what we have done is just derived the weighted average of the fruits. • when we have 2 different items and if we want to take its average: You should multiply each item with its corresponding weight (in this case the apples with apple price and oranges with oranges price and then take the average using total no. of fruits) What is WACC, why is it needed and Where is it used? • What is WACC ? • So, why am I teaching you this with fruits? • Lets replace the basket with your company and fruits with capital. • You may have acquired capital from many sources. • Like by selling equity: You sold equity in your company to acquire capital from investors. • Like taking loans from banks on interest rates. • If you consider, Apple as equity and Oranges as debt and for the equity you are paying some 4% per annum (this number is derived using a technique called CAPM), I have already made a video on that, please watch it after this video. And for debt, let’s say you are paying some 8% interest per annum. • 4% is going to become your cost of capital for (capital acquired through equity) • 8% is going to become your cost of capital on (capital acquired through debt) (Equity Capital X 4%) + (Debt Capital X8%) ---------------------------------------------------------Total Capital • So, what we have done is just derived the weighted average Cost of Capital. • Basically, we are taking all the different forms in which we have collected Capital for the company and calculating the average cost of capital using weighted average method. • I will explain in detail, after few minutes how to calculate the know the cost of capital for different types of capital Why is WACC needed and where is it used? • Why is WACC needed? Or let’s call it Why do we need to derive WACC number • WACC tell us that the minimum returns that a company needs to generate to pay to its investors and lenders. • Once you know returns percentage, i.e., WACC. This will tell the business leaders that any project they undertake, it has to ensure that they generate more than the WACC otherwise it is not worth undertaking the project as it would be deemed as a loss. • This is why knowing WACC is important. Where is WACC used? • WACC is used in Capital budgeting techniques as a discounted rate for the long term projects that company undertakes. • If you are not sure about Capital budgeting or Discounted rate, then please watch the video I made on Capital budgeting techniques and it’s a highly successful video, you will understand entire capital budgeting in less than 30 mins. Break down of the word • Weighted Average • Cost of Capital We already looked in to the Cost of capital and how to use weighted average for different forms of capital that company holds (like equity, debt etc). Types of Capital • Primarily 3 types of capital in a company. • 1. Debts (Bank Loans, Bonds) • 2. Preferred Stock (also called as Preferred equity) • These are different kind of stocks issued by a company unlike the common stock. • These stocks are promised to give higher dividends, they have a maturity date before they can be redeemed but they receive dividends on yearly basis. • These can be brough on the market like we buy the common stocks through company or through broker. • 3. Equity (Common stock) (also called as common equity) - if you don’t know what equity is, please watch my equity and their types video How to compute Cost on those types of capital? • Easiest of all is Debt, You know the interest rate you are paying on the debt acquired. • Example: 8% per annum on bank loans and 5% per annum of Bonds issued • Preferred stock: Dividend issued on preferred stock per share divided by Preferred stock price per share • Example: if dividend paid is $5 dollars per share per annum and the current market price of the preferred stock is $50 dollars. Then cost of preferred stock is 5/50 = 0.1 (0.1X100 = 10%). So 10% is the cost of preferred stock. • Equity: This one is tricky. There is no direct way. There are 3 common approaches. A company may choose to pick one of them. They are 1. CAPM, 2. Dividend discount model and 3. Bond Yield Plus Risk Premium model. • CAPM – Capital Asset Pricing Model (Mostly Robust and >70% of the firms use it) – I have already made a video on it. Please watch it and you will understand how to come up with CAPM number for your equity. • Dividend Discount Model - ((D/P)+g) (D- expected Dividend per share, P- Current market price of equity, gthe expected growth rate of the dividends) • Bond Yield Plus Risk Premium Model (YTM+Risk Premium) (YTM is Yield to Maturity, Risk Premium) Formula for WACC •WACC = wdrd + wprp + wede • • • • • • w=weight r=cost d= debt p=preferred stock e=equity t=tax percentage of the firm •WACC = wdrd (1-t) + wprp + wede • Preferred stock, equity are calculated after tax (You would need to pay the taxes on the equity and preferred stock). They are paid post taxes. • However, debt is tax deductible ( meaning you don’t need to pay tax on the interest rate you are paying) Application of WACC in Capital Budgeting • To invest in a project. • If a company ‘s WACC is 8% then the project a company should invest should be greater than 8% otherwise the project is not financially viable for the company. • Used as a discount rate or opportunity cost of capital in Capital budgeting techniques. • WACC is also known as MCC (Marginal Cost of Capital) Useful links 1. 2. 3. 4. 5. Pmtycoon Recommended Courses: https://tinyurl.com/pmtycoon-advised-courses Follow me on Instagram: https://www.instagram.com/pmtycoon/ Follow me on Twitter: https://twitter.com/pm_Tycoon Subscribe to my YouTube channel: https://tinyurl.com/pmtycoon-subscribe Pmtycoon’ s Google Drive: https://tinyurl.com/pmtycoon-Google-Drive What’s next in the videos? CFA series coming soon!
