Weighted average cost of capital
Have you ever gone grocery shopping with your parents and noticed that the things they buy have different prices? Some things might be cheap while others are more expensive. It's the same with a company. A company needs money to grow and run their business. They can get this money by borrowing it from a bank or investors or by selling shares of their company to people who want to invest in it.
Weighted average cost of capital (WACC) is the cost a company pays to get this money. Just like how some things at the grocery store are expensive and some are cheap, the different ways a company can get money have different costs. Some might have a high interest rate, while others have a lower rate.
To calculate the WACC, we need to add up all the different costs of getting money, like the cost of borrowing from a bank, issuing shares, or taking out a loan, and finding the average of them. But here's where it gets tricky: not all of these costs are weighted the same.
Think of it like a cake. Let's say you make a cake and use flour, sugar, eggs, and butter. But you use more flour than the other ingredients. That means the flour "weighs" more in the cake. Similarly, when calculating WACC, the different ways a company can get money are "weighted" based on how much of it they use.
Now, remember that a company can get money from borrowing, issuing shares, or taking out a loan? Let's say a company borrowed $10 million from a bank with a 5% interest rate, issued $5 million in shares with a 10% return, and took out a $2 million loan with a 7% interest rate.
To calculate the WACC, we would take the cost of each source of money (5%, 10%, and 7%), multiply it by the percentage of total money borrowed from each source (10/17, 5/17, and 2/17), and then add them together. This weighted average would give us the overall cost of getting money for the company, or the WACC.
It's important for a company to know their WACC because it helps them decide if a new investment or project is worth it. If the WACC is high, it means the cost of getting money is expensive, and the investment needs to make more money to cover that cost. On the other hand, if the WACC is low, it means the cost of getting money is cheaper, and the investment doesn't need to make as much money to cover the cost.
So think of WACC like baking a cake. You need different ingredients that have different costs, and you have to use more of some ingredients than others. But when you put it all together, you get a delicious (and hopefully profitable) result!
Weighted average cost of capital (WACC) is the cost a company pays to get this money. Just like how some things at the grocery store are expensive and some are cheap, the different ways a company can get money have different costs. Some might have a high interest rate, while others have a lower rate.
To calculate the WACC, we need to add up all the different costs of getting money, like the cost of borrowing from a bank, issuing shares, or taking out a loan, and finding the average of them. But here's where it gets tricky: not all of these costs are weighted the same.
Think of it like a cake. Let's say you make a cake and use flour, sugar, eggs, and butter. But you use more flour than the other ingredients. That means the flour "weighs" more in the cake. Similarly, when calculating WACC, the different ways a company can get money are "weighted" based on how much of it they use.
Now, remember that a company can get money from borrowing, issuing shares, or taking out a loan? Let's say a company borrowed $10 million from a bank with a 5% interest rate, issued $5 million in shares with a 10% return, and took out a $2 million loan with a 7% interest rate.
To calculate the WACC, we would take the cost of each source of money (5%, 10%, and 7%), multiply it by the percentage of total money borrowed from each source (10/17, 5/17, and 2/17), and then add them together. This weighted average would give us the overall cost of getting money for the company, or the WACC.
It's important for a company to know their WACC because it helps them decide if a new investment or project is worth it. If the WACC is high, it means the cost of getting money is expensive, and the investment needs to make more money to cover that cost. On the other hand, if the WACC is low, it means the cost of getting money is cheaper, and the investment doesn't need to make as much money to cover the cost.
So think of WACC like baking a cake. You need different ingredients that have different costs, and you have to use more of some ingredients than others. But when you put it all together, you get a delicious (and hopefully profitable) result!
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