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WACC in 3 Easy Steps - How to Calculate Weighted Average Cost of Capital Finance
Hello and welcome back again to MBABullshit.com. So our topic for this video is WACC or the
Weighted Average Cost of Capital. So before anything else, remember you can always go
back to MBAbullshit.com. There are lots of different videos on business topics for business
students, MBA students, business college students, BBA students, etc.
But before we move on, I’d like to point out that I highly recommend that before watching
this video, she already understand the concepts of Present Value, Future Value, Internal Rate
of Return and Cost of Equity. If you don’t know those yet, then you might want to first
watch my other free videos on these topics above. Alright so let's get down to it.
So first of all before we move on, I’d like to ask you first. What is the meaning of Capital
in the business? I’m not talking about the capital of America Washington DC or whatever.
When we talked about a business, what do we mean by Capital? Well, it means, it talks
about the money which is used to start or run or expand a business. For example, in
this case here, let’s say you want to put up a store, a store business; you need money
so that you can buy the products to sell in the store, so that you can buy the shelves
in the store, so that you can buy the uniforms in the store and things like that. So the
money that you used to start your business is called Capital.
Now the next question is where does Capital come from when you put up a business? Well,
there are two main sources. There are usually two places from where you get Capital. The
first place is or the first way is to borrow from banks. Sometimes you don’t have enough
money to put up your own business and so you borrow money from the banks and this is called
Debt. The next source or the other source, other mean source is when the owners or the
investors such as yourself put your own money into the company. And this is called Equity.
In MBABullshit language or in business *** language, we don’t say borrowing from the
banks because it doesn’t sound too good, it doesn’t sound too sophisticated. So instead
we say Debt. And when the owners put their own money in the company, it doesn’t sound
so pretty either, so we use the word Equity. Now, let’s asked ourselves what is the Cost
of Debt? Remember, Debt is different from Cost of Debt. So what is the difference? What
is the Cost of Debt? Well remember that Debt means you’re borrowing from the bank and
so the Cost of Debt means or usually means the bank interest rate percentage that is
charged to your company. For example, remember when the bank lends you money, they don’t
lend you the money for free. The bank needs to earn money from lending you money so the
bank will charge you an interest rate. For this example, let’s just pretend; let’s
just assume that it is 5%. Now let’s go to the next source of Capital
which is Equity. And we also ask; what is the Cost of Equity? When you put your own
money in the company or when your investor or your friend maybe puts his money in your
company so that he can be a partner in your company or he can be a shareholder in your
company. Many people think that when you put your own money in a company or when an investor
put his or her own money in a company, then it’s free because you don’t have to pay
interest rate of 5% like with Debt. So people think that the Cost of Equity is free. Well
actually it’s not free. Why is it not free? It’s because there’s what we called an
expected return or expected profit from these owners or investors. If your friend or maybe
not your friend or investor like this scary lady over here puts her money in your company,
it’s because she expects to earn money from putting her money in your company. She expects
to earn money from her investment and this is called an Expected Return. And this is
usually higher than bank interest rates. Why is it higher than that? Because if you’re
going to pay her or if she going to earn less than the bank interest rates then it’s better
for her to put her money in a risk free deposit in the ban instead of in your company. So
usually this is higher. Now in this case let’s just pretend that it’s 10%. However in other
problems, it might not be as simple as 10% maybe in our case I’m giving you the information,
I’m telling you it’s 10% but in other cases you might be given other information
and then you would have to compute this amount yourself using the CAPM or the Capital Asset
Pricing Model or Cost of Equity formula which I already talked about in my other video.
But in this case, let’s just pretend we already know that the expected return, the
expected profit of the owner or the investor is 10%. So now we move on.
Let’s ask ourselves the next question: what is the cost of Capital? Remember Capital comes
from either Debt or it comes from Equity. So what is the Cost of Capital? Well it’s
easy. It depends where did you get your money to start or run the company. Did you get it
from Debt? Or did you get it from Equity? Where did you get it? Which one did you get
it from? Now, if you got your money from bank borrowing at 5% interest as you remember from
the last slide then your Cost of Capital is exactly the same as your Cost of Debt which
is 5%. You remember here it’s 5%. So it’s the same. It’s the same if you got your
money from bank borrowing at 5% then your Cost of Capital is the same. It is also 5%.
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