Every business owner should know their WACC and use it in strategic decisions. Watch my weekly video to find out more!
VIDEO SUMMARY
What is WACC? It is based on a simple idea. Every dollar in an organization has a cost. That cost is WACC. Your business is a machine. You have capital flowing in one side and profits flowing out the other side. For example, $1 flowing in and $2 flowing out. There is a cost to the capital flowing in. That cost is associated with the riskiness of your business. The riskiness of the $2 in profits is going to factor into the price of the capital flowing in. Investors are considering giving capital to your company and they will price it accordingly.
How do you figure the price of capital? You basically take the weighted average, looking at both debt and equity. I show the equation in the video. You can factor in other elements of capital as well. You have the weight of equity times the cost of equity plus the weight of debt times the cost of debt (factoring in tax benefits of debt). The cost of debt is easy to figure out, because you are making interest payments. The cost of equity is trickier, but there is always a cost and it is higher than debt, because it is riskier than debt. Some people think there is no cost to equity, but it is baked into the price based on risk.
So WACC gives you an overall cost of capital for the company. This is a value every business owner should know. It can be used to make strategic financial decisions. A business leader looks at investment opportunities. All investments have costs and profitability associated with them. It is important when making those decisions to understand what the cost of capital is going to be. Let’s say you are building a new factory. If the investment generates 20% profit. If the cost of capital is 10%, the true profit is only 10%. I hope people realize that all the decisions you are making should tie into the cost of capital.
Another reason this is important, WACC is a lever that affects the profitability across your entire company. Even before the capital flows in, if you can lower the cost of capital, even by a little bit, it increases your profitability across your entire company.
Leave a comment down below letting me know what you think! If you find these videos helpful, please subscribe to my YouTube channel.
Neither Zach De Gregorio or Wolves and Finance Inc. shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.