Hey YouTube, Jimmy here.
Once again, we're taking a break from our DOW 30 analysis with a quick investing basics
video on WACC or weighted average cost of capital.
We're looking at how it's calculated and how can be used effectively weighted average cost
of capital is often called WACC for short.
Basically, WACC is a way to calculate the cost of capital for a company considers the
cost of debt, the cost of preferred shares, if the company has any, and the cost of the
company's Equity.
So, let's look a bit closer the formula for calculating WACC looks like this.
Although this formula may look a bit long at first.
It's quite intuitive once you break it down before we even tackle the formula.
Let's walk through a quick example.
So, let's imagine that company XYZ decides to go out in raise $100,000 to grow their
business.
They've decided to issue Bonds in the amount of $30,000 and then they sell $70,000 worth
of equity to get them to the hundred thousand dollars that they're looking for.
So now they have $100,000 in total market value.
So, the first question we tackle when looking to calculate WACC is what percentage of that
$100,000 is Debt and what percentage Equity is well the $30,000 in debt / the $100,000
in total market value tells us that the debt portion is 30%.
And since in this case.
We have no preferred shares to consider while we know that the equity portion is 70% So
now the math is quite simple.
Let's imagine of the cost of debt is 4% and debt is generally quite simple to calculate.
What is the interest rate on the debt?
In this example, we can say that we only have one bond for $30,000 and therefore we can
just use the interest rate with pay on that bond which were saying is 4%.
Now to make it even simpler many public companies publish their average cost of debt.
So, you can generally just use what they give you in the footnotes of the financial statements.
But for example, we're going to stick with the 4%.
Now jumping over to the cost of equity.
Generally, you would have to use something like the capital asset pricing model to come
up with the cost of equity and that's a whole different calculation and we recently published
a video on the capital asset pricing model.
So if you're interested in seeing how to come up with it, you can jump over to that video,
but for this example, let's just assume that the cost of equity is 10% Generally the cost
of equity is going to be higher than the cost of debt since Equity shareholders bear more
risk than bondholders and therefore Equity holders demand a higher rate of return the
debt holders this can be thought of as what the equity investor expects the company to
return for them.
So, let’s slide back over to the formula.
So, as you may notice, there are two primary letters.
"w" stands for weight in "r" stands for the percentage cost often, it's called the required
rate of return hence the letter r.
So, the Wd stand for the weight of the debt we know that's 30% the Rd stand for the cost
of debt.
We know that's 4% So I'm going to skip this 1-t for now.
I'll come back to that in a second.
Wp is a weight of the preferred shares RP is the cost of the preferred shares.
We don't have any preferred shares right now, which makes this whole section zero and here
e for Equity.
We have 70% weight and 10% required rate of return.
Okay, so jumping back to the debt for a second this 1 - t.
t stands for tax rate.
As you can see this only applies to the debt because debt has a unique feature of usually
having interest payments that are tax-deductible the 4% Well, that's an expense but that expense
is before taxes.
So, if their tax rate is 25% then you take 1-t where t is .25, which is a 25% tax rate
and you end up with .75.
This is a tax adjustment you're making to the cost of debt.
So for our example, after accounting for the tax benefits of debt, this makes the cost
of debt just 3% So as you can see this formula is not terribly difficult and at the end of
the day WACC tells you the minimum amount a company needs to return the company can
use this as a way to determine if they should invest in a project.
So, if company XYZ calculates, they're WACC to be the same 7.9% we calculated, and they
find a project that's going to return an estimated 6% Well, they shouldn't do it.
They would be destroying wealth of the company since the capital they will be using would
be costing them 7.9% and it would be earning 6% but if on the flip side.
They thought the project would earn 17.9% Will they should probably do that since they
would be creating wealth has a cost of capital would be 7.9% and they would be earning 17.9%
in to see how much of an impact this can have from a company perspective, so the company
ends up with a 10% return that means for every dollar the company invests in the project
$0.10 in wealth will be created for the company another good use of WACC is to use it as a
discount factor in discounted cash flow or some similar valuation technique and it works
very similar to the way a company would use it.
So, using the WACC we calculated of 7.9% Well, we can use that number to Discount expected
cash flows to see what they're worth today.
So, if cash flows are expected to be 1 million dollars in 2 years for a company we are considering
investing in today.
Well that $1,000,000 in 2 years is worth $858,929 today.
... Let's pretend that the company we're looking at has 10,000 shares outstanding divide this
by 10,000 and you get a present value of $85.89 per share.
Well, if our expectations are correct about future cash flows, this is what the stock
should be worth today.
Let's pretend that this stock is trading at just $60 a share.
Well, it could be undervalued, and we can consider buying it.
But if instead the stock is trading at $100 a share.
Perhaps, it is overvalued, and we should find a different opportunity for our hard-earned
money.
So that's the basics of weighted average cost of capital and how it can be used.
If you made it this far in the video.
I hope you found it useful and if you have any comments, questions, or general thoughts.
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button and I'll see you in the next video.