FIN 62 Module 11 Intro - Weighted Average Cost of Capital

Let's take a look at Module 11, Weighted Average Cost of Capital. So it's all in the name, but the name might not mean much to you. Weighted average. So basically the average, and we'll talk about what weighted average means here in a second. Cost of capital means how expensive is it for us to get long-term funding, right? Funding for our projects. And if you raise money from shareholders, that has one cost, the cost of equity. If you raise money from debt holders, that has a different cost, cost of debt. And so the idea is we're going to figure out the company's cost of equity, their cost of debt, and then figure out their overall sort of cost of capital for the company. And that's the weighted average cost of capital. Now, why do I need to know what's the cost of capital for the company? And the answer is it's useful in considering the discount rate for projects. Now this isn't used, well, it could be used as a discount rate, but every project is going to be a little different, but it's a good baseline for the company to say, well, this is how much it costs us to get long-term funding. So when I'm figuring out a long-term project, it's often used as a baseline for the discount rate. Now they might calculate this number and tweak it higher or lower depending on the risk of the project, but this is a useful baseline number for the discount rate, the required rate of return of a project. So it's a fundamental concept in finance and it's actually a pretty straightforward concept in finance. So we look at a company's balance sheet and we say, okay, here's this fake company made up with $2 million in liabilities and $3 million in equity balancing to $5 million in total assets. We want to say, well, our long-term funding, our liabilities and equity, what is the cost of that long-term funding? So we would determine the borrowing cost by looking at things like our bonds and the yield to maturity on our bonds. That is our borrowing cost. So let's say we did some calculations and you will likely have to do this. When you do the chapter, you'll have to figure out, okay, well, you know, with bond math from chapter four, figure out the yield to maturity, the eye on the bond, the rate of return on the bond. And let's say our bond rate is 8%. What's the cost of borrowing on a bond then? Well, you might think, well, it's 8% because that's the borrowing cost of the bond. But because bonds create interest expense and that 8% is an interest cost, actually we don't pay the full 8%. It reduces our tax bill by 25%. We pay 8% times one minus the tax rate. 8% times one minus T is one minus 0.25 is 0.75. We pay 6%, 8% times 0.75 is 6%. So on our $2 million of liabilities, the cost of capital is 6%. On our cost of equity and how would I determine cost of equity? Well, with borrowing cost, you do bond math typically. It might be given in your question in your class, but very often the professor will make you do some math related to bonds and you figure out the yield to maturity and that's the eye in your financial calculator. With cost of equity, again, the professor likely won't give you that number. We are doing it here because it's intro to the chapter, but you'll see in chapter question, I make you calculate it. With cost of equity, it can either be derived depending on what information is given by using the dividend discount model we introduced in previous chapters or more likely what we did last chapter, CAPM, capital assets pricing model. And that's the expected return on an investment. That is our internal cost of equity for the shareholder. That's how much money they're getting for us. That's our cost of equity. So typically going to be derived using the CAPM formula, which if you're not sure what that is, you're going to have to revisit last chapter's material. I revisit again this chapter, but just so you know, this number, it might be given to you in the question, but it's very often something that the professor makes you calculate. So let's just say we say our cost of equity is 12%. Okay. So if I were to take a simple average here, six and 12, the average and cost of debt liabilities is always going to be cheaper than cost of equity. If for no other reason, then it's interest is tax deductible. So it always tends to be cheaper. If I were to take an average between six and 12, I would go six plus 12 is 18, 18 divided by two, my average cost here is 9%, but I have more equity than I have liabilities. So this is where the weighted average comes in. If I look at my total liabilities and equity, it's $5 million, right? Just add the two together. My okay. And my debt is two and my equity is three to total five. Well, of this $5 million, you can do some quick math. The two divided by five is four 40% and three to three divided by five is 60%. I'm 40% debt, 60% equity. That's the relative weight. So to figure out the weighted average, we just multiply. We don't add together and divide by two. We multiply this one by 40%. We multiply this one by 60% and then we're going to add them together. And that'll give us our weighted average cost of capital. So six times 40 is 2.4%. 12 times 60 is 7.2%. Add them together. Two plus seven is nine, four plus two is six, 9.6%. So you can see our average cost of capital is nine, but that's not a relevant number. The weighted average is 9.6. And why? Because equity has more weight than debt in our average, because there's more equity than there is debt. So assuming the company is going to continue with the same sort of debt equity ratio, this is the cost of capital. And so this number 9.6% can be used as a baseline in determining discount rates and things like that. So that's why weighted average cost of capital is a core component to the question. You're thinking about, you know, long-term financing, right? You're thinking about new projects as we are all the time in finance. And you're saying, well, what's the discount rate of this? And this is a great starting point. Well, this is how much it costs us to get money. 9.6% on average. So, you know, we're going to want to make more than that in our returns and, and you might make it much higher. If it's a very risky product project, maybe a little lower, if it's not a very risky project, but this is a great starting line for that required rate of return. There you go. The weighted average cost of capital. We're going to do tons of calculations. This module stay tuned.