- We are now ready to talk about the important topic of the Weighted Average Cost of Capital, or the WACC. A company's capital structure determines how costly it is to obtain external financing. Let's consider Lilly's case three, where Lilly gets half of her financing from lenders, and half of her financing from investors or partners. 100 million from the lenders, half. And 100 million from investors, half. The Weighted Average Cost of Capital is then just the average of those two sources of financing, the cost of those two sources of financing.
Five percent for the lenders, seventeen percent for the investors. The Weighted Average Cost of Capital, just putting those two together, half weight on each one of them, is 11 percent. How is Lilly going to use this 11 percent number? She's going to say it's going to cost me on average, 11 percent in order to get the money to do my project. Will the project generate 11 percent? If it's only going to generate 10 percent, I'm not going to get the financing, and I don't want the financing, it's not a good project. On the other hand, if the project's going to generate 15 percent, and my Cost of Capital is only 11 percent, this is a very good project, this ice cream company.
The Weighted Average Cost of Capital tells a company, what does it cost us to get money. And then the company uses that number to evaluate the attractiveness of various projects. We can compute the Weighted Average Cost of Capital in each one of Lilly's four cases. The 100% debt case, 100% equity, 50/50 debt and equity, or 90/10 debt and equity. And the Weighted Average Cost of Capital in each case, is the cost of the debt multiplied by the fraction of the financing provided by the lenders, plus the cost of the equity multiplied by the proportion of the financing provided by the owners, the partners, the equity holders.
In this case, we see that case three, the fifty fifty split, provides the lowest average Weighted Cost of Capital. And you can think of the whole purpose of capital structure, and getting the optimal capital structure, is to find the capital structure that will give a company it's lowest Weighted Average Cost of Capital. Because if your Cost of Capital is lower, that means there are more attractive projects out there. If my Cost of Capital is only 11 percent, I can find many more attractive projects that will be profitable, than if my Cost of Capital is 15 percent.
The objective of corporate finance and capital structure, is to find the capital structure that will provide the lowest Weighted Average Cost of Capital, the WACC.
- Understanding financial statements
- Managing finances in the short term
- Analyzing risk and return
- Obtaining short-term and long-term financing
- Understanding the stock and bond markets
- Comparing the Facebook and Microsoft IPOs
- Working with financial institutions
- Using capital budgeting
- Creating simple personal saving and investment plans