3-Minute Overview: (Also Download Free Cheat Sheet at Bottom)
Part 1
Part 2
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- Money (capital) needed to run a company comes from either borrowing (debt) or the owners’ money (equity).
- The COST of capital is either the interest payment on the debt, or the required profit that the owners want in return for their investment (in MBA bullshit language: “expected return”).
- The expected return or COST OF EQUITY is determined by another financial model, the CAPM or the CAPITAL ASSET PRICING MODEL.
- When you COMBINE BOTH the interest rate of debt AND the ‘expected return’ of the investors/owners, we get the total cost of capital.
- If the cost of debt (e.g. interest) and cost of equity (expected return) are different, then we have to get an AVERAGE of the two to get our COST OF CAPITAL
- Cost of capital is expressed as a percentage; because it’s compared to the total capital (as a percentage of the total capital). Just like bank loan interest is expressed as a percentage of your total loan.
- What if your company has more debt vs. equity, OR vice versa? Then our formula must give more importance or ‘WEIGHT’ to whichever is bigger; and must give LESS weight to whichever is SMALLER. Thus, we have the WACC or Weighted Average Cost of Capital concept.
- This is the basic WACC or Weighted Average Cost of Capital Formula:
WACC = (Debt Proportion)(Cost of Debt %)(1 – tax rate %) + (Equity Proportion)(Cost of Equity %)
- To understand this formula step-by-step in action, watch my free video below.
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