🔴 Weighted Average Cost of Capital or WACC Explained (Quickest Overview)

Summary

This video explains the concept of Weighted Average Cost of Capital (WACC), which helps businesses calculate their overall cost of financing by weighing the costs of debt (bank loans) and equity (investors' capital). The cost of debt is the interest rate on loans, while the cost of equity is the expected return for investors. By combining these costs based on their respective proportions, WACC provides an accurate measure of the true cost of capital for a business. The video encourages viewers to learn more through an easy-to-understand video and free resources.

Takeaways

• 😀 Capital is essential for business, and it can come from owners' equity or borrowing (debt).
• 😀 Borrowing capital from a bank incurs a cost, which is the interest rate on the loan.
• 😀 If you borrow at a 5% interest rate, your cost of capital is 5%.
• 😀 If your capital comes from investors, the cost is the expected return on investment, such as 10%.
• 😀 The cost of capital is not just the interest rate or expected return—it’s a weighted average of both.
• 😀 A weighted average cost of capital (WACC) is calculated based on the proportion of borrowed capital and investors' equity.
• 😀 The WACC gives more weight to the capital source that is greater (either the loan or investor equity).
• 😀 If part of your capital is borrowed at 5% and part comes from investors expecting 10%, your WACC will be somewhere between these two rates.
• 😀 WACC is not a simple average but a weighted calculation that reflects the relative size of each funding source.
• 😀 Learning how to calculate WACC is simple and provides insight into your business's capital costs.
• 😀 For a deeper understanding, free resources like videos and cheat-sheets on WACC are available at MBAbullshit.com.

Q & A

What is capital in a business context?

Capital refers to the money a business needs to operate, which can be obtained through the owner's money or by borrowing from sources such as banks.

What are the two main ways a business can obtain capital?

A business can obtain capital either through equity (owner's money) or by borrowing (debt), such as from a bank or other sources.

What is the cost of capital when borrowing from a bank?

The cost of capital when borrowing from a bank is the interest on the loan. For example, if the interest rate is 5%, then the cost of capital is also 5%.

What happens when the capital comes from investors instead of a bank loan?

If capital comes from investors, the cost of capital is the expected return on investment. For example, if investors expect a 10% return, the cost of capital is 10%.

What is meant by 'weighted' average cost of capital?

The 'weighted' average cost of capital takes into account both borrowed capital and investors' money, giving more importance to whichever source is greater in proportion.

How is the cost of capital determined when a business has both debt and equity?

When a business has both debt and equity, the cost of capital is calculated as a weighted average based on the proportion of each source. This means the cost will be somewhere between the interest rate on the debt and the expected return from equity investors.

What formula is used to calculate the exact cost of capital?

The exact cost of capital is calculated using the WACC (Weighted Average Cost of Capital) formula, which factors in both debt and equity and their respective proportions.

How does the WACC formula work in practice?

The WACC formula calculates the cost of capital by applying a 'weight' to each source of capital, such as debt and equity, depending on how much capital comes from each source.

Why is the WACC formula considered important for businesses?

The WACC formula is important because it helps businesses determine the overall cost of their capital and assess whether investments are worthwhile based on the cost of obtaining funds.

Is calculating WACC complicated?

No, calculating WACC is relatively straightforward once you understand the basic concept. It simply involves weighting the costs of debt and equity according to their proportions in the capital structure.