New Jersey Forensic Accountant Explains "WACC"
Hi, everyone. Robert A. Bonavito, CPA, here, also known as the New Jersey Forensic accountant. Today I'm going to discuss a topic that has a lot of uses. And that is weighted average cost of capital, also known as WACC. What is WACC? WACC basically gives you the cost of your money. Just like when you buy a car or a house, you have a cost of money, right? You have to get a car loan, you have to get a mortgage, that's your cost of money.
Now, for a company buying another company or evaluated product, a little bit more complicated. The important thing to realize is once you calculate your WACC, you know the cost. Then if you could figure out what the benefits are as far as free cash flow, you can figure out if it's going to be worth your while to make that investment.
Now, WACC is not going to give you the absolute correct answer. But it's definitely going to give you a series of logical steps in which you can properly evaluate a project or the purchase of a company. Now remember, you could even calculate WACC if you're thinking of buying a business a franchise or opening a company, what it costs you to borrow that money.
WACC is an extremely important concept because of this power that it has in order to give you tools to make intelligent decisions, based on what it cost you to borrow money and what you expect to get from that company or that project because when you look at the purchase of a company, hopefully, you're looking at future cash flows. You're going to get going out three, five or 10 or 20 years or if you're making a project, it will give you some cash flows you can calculate. And using that WACC, you can capitalize it or get the debt present value and figure out if it's worth it.
Now, let me just look at this one screen here. This is the formula to calculate WACC. And again, WACC basically is applied to usually free cash flows. So that's what we do in my business mainly is look at the valuation when we value a business or a project to determine if it's something we could consider. Now, here's the formula. Basically, we're showing WACC is equity divided by the value of the company's debt and equity times the rate that we borrow the equity in the data. That's all this is saying.
See we have here formulas, it says A is the market value of the company, D is the market value of the company's debt, V is the market value of the company's total, E and D which is equity and debt combined, Re is the cost of equity, Rd is the cost of debt, and, of course, we have to calculate taxes. Hopefully, we're making money on this.
Now I'm just going to go through a quick simple example here so that you can get a better idea of how this will work. Now, let's just assume that we have a company, you and I together. It's called RAB Industrial Company. It's located in New Jersey, of course. That's where all successful businesses are located. And we want to expand and diversify our company.
Now, obviously, industrial companies are not in vogue right now. And I don't think they're either going to be in vogue for a long time. So, we're thinking of going into the cloud and purchasing an AI program called Alpha 1. Now the cost of this company is $1 billion. Let's assume that in order to raise the $1 billion, we need to sell stock and we need to raise debt. And we're probably going to issue bonds.
So, in this scenario, we're going to sell 60,000 shares of stock for $10,000 each. We're going to raise $600 million. The shareholders who are out buying this stock, obviously, are not doing it because they're our friends. They're doing it because they did their calculations. And they determined that they should earn about 6% from this investment. And they did a calculation in their mind.
They said "Well, I'd rather buy this stock and earn 6% into the foreseeable future than let it sit in the bank earning 1% or 2%." That would be what's called the risk-free rate. So they determined that this is worth it. We have a good company. We have a good management team. They will buy the stock. And we raised $600 million.
Now, we're still short. So, we also decide to issue $400,000 in bonds for $1,000 each to raise an additional $400 million in capital. Now, the people buying the bond are earning 2.5% interest every six months. And they total annual return they'll get is 5%. That's our cost of debt. We had to give them 5% to get the $400 million, just like we had to give the shareholders 6% to get the $600 million.
So, now that we've raised the capital, we can go and buy Alpha 1. And we need to now calculate what it cost us to raise the $1 billion because remember, you have equity that we had a promise or, you know, the shareholders think we're going to give him 6%. Hopefully, things work out. And the debt holders actually do have a promise from us for 5%.
Now, we do this calculation. It's pretty straightforward, which I have here where we're simply dividing the amount of capital into the total we raised for equity and debt and multiplying it by the rate of interest. Now, debt has a little bit more complicated calculation because obviously, as a company, when we pay someone interest expense, we could write that off. So, we get a subsidy from the government because if I give someone $100, I have $100 expense on my profit and loss statement. But I don't have to pay taxes because that's an expense. It reduces my taxable income.
So, basically, the government is subsidizing our loan. To give someone $1,000 of interest only cost me $650. So I get that subsidy from the U.S. government, in effect. That is one reason why companies like to borrow debt. Though it does increase risk, we can borrow a lot cheaper than usually from a bank or a bondholder than we can from shareholders, as in this case, because we're paying our shareholder.
Concerning this, feel free to give me a call or probably the best thing to do is email me. And I'll get back to you. But the concept is pretty straightforward. It's just a matter of working it through and using it. That's the key. You need to use this in your real life. You need to use this if you own a business or you're thinking of owning a business. Nice.