Weighted Average Cost of Capital

Weighted Average Cost of Capital
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  • 0:03 Project Decision
  • 0:58 How Businesses Raise Money
  • 1:56 Weighted Average Cost…
  • 4:18 Lesson Summary
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Lesson Transcript
Instructor: James Walsh

M.B.A. Veteran Business and Economics teacher at a number of community colleges and in the for profit sector.

Let's see how calculating the weighted average cost of capital can help a business make a decision about going ahead with a new project. This lesson takes you through the process and illustrates the WACC calculation.

Project Decision

The CEO and Research Director at Speedy Cellular are getting excited. The research team has been working on a new cellphone battery that will last twice as long between charges as the one they use now. The new battery has passed its last big test and is ready to be installed in their new model phones. ''Everyone is going to want one of these phones,'' the CEO says. ''They'll be flying off the shelves as fast as we can make them. We're going to need to build a new factory to make the batteries, though.''

Tracie is the Chief Financial Officer at Speedy. She has a meeting scheduled for tomorrow to talk about the new battery factory with the CEO and other executives and decide whether it will be a profitable venture for the company. Tracie is familiar with how this works. The CEO and marketing people will figure out the rate of return from the factory. Tracie's job is to figure out the cost side; that is, the percentage Speedy will need to pay to raise the millions needed to build the new factory.

How Businesses Raise Money

Like most companies, Speedy raises money for new projects and investments in two ways: one is to borrow it from a bank or other credit institution, or issue bonds to investors who'll be paid interest on their investment. This is called debt financing. Speedy pays a specific interest rate for the money it borrows; the bank gets the rate on the loan documents, and the bond investors get the rate for the bond issue.

The other method is equity financing, which comes from selling new shares of common and preferred stock to investors or getting money in return for ownership in the company. The cost of equity isn't specific like it is for the debt part. Speedy knows it won't get smart investors to give them their money or buy their stock unless they get a return for it. The return investors will expect can be estimated with fancy financial models; but, for our purposes, we'll call the cost of equity the percentage return that Speedy must provide to its equity investors to keep them from selling their stock or withdrawing their money.

Weighted Average Cost of Capital

Now, Tracie is going to put the pieces together and figure out the weighted average cost of capital (WACC) for Speedy Cellular. WACC is the cost of capital (or funds) where each source, debt and equity, are proportionally weighted. If the rate of return for the new battery factory is greater than the WACC, the project will be profitable and will get the green light. Here's the formula Tracie uses for the WACC:

WACC = Wd (KD (1 - t)) + We (Ke)

Where:

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