Understanding the Weighted Average Cost of Capital
My name's Robert Bonavito, New Jersey forensic accountant. This video is part of a series of videos where I discuss forensic accounting topics for educational purposes only. If this was a litigated matter, I would take a different approach, have different conclusions based on different facts and circumstances.
Today's topic is understanding weighted average cost of capital. Sounds kinda complicated. Really not that complicated when you when you break it down. What is weighted average cost of capital? I mean, cost of capital is...it's important to understand what your capital cost...even if you have a small business, you're investing money and time in that business. And with some of the most sophisticated companies, you know, you'll have stockholder equity and long-term debt. And when we do valuations in these companies, we have to figure out what the way to cost the capital is. I have a pretty simplified example here so it's easy to understand, I think anyway. But a company has two sources of capital, usually stockholders, you know, investments which is paid in capital that's when they buy the stock in the company, and debt. You take on long-term debt. Small businesses usually have both, but they don't realize it. You know, someone will start a business, they'll put, you know, $2,000 in the business and perhaps they'll go to the bank and get a line of credit or something like that, and that's their capital to start the business up. And the reason you have two types of capital is remember, and if you have debt, when you pay the debt, the interest expense is deductible. So if you're in the 40% tax bracket and the interest rate is 10%, your effective interest rate is only gonna be 6% because you have a tax break from the U.S. government, they're paying some of the interest for you. So really the debt is not costing you 10%, it's costing you 6%.
And the other big advantage to debt is when you buy an asset, you know, it will increase in value based on inflation. So for example, if I was to buy a warehouse, and inflation was let's say 3% or 2%, that warehouse is not depreciating hopefully, it's increasing in value. You know, it's kinda like, you know, when your parents bought a house and they bought it for $10,000 and they sold it 30 years later for $300,000, that is inflation increasing the value of the asset, but what happens to the debt? Okay, so if you bought a house for $150,000, and let's say you took...let's say you bought a house for $300,000, and you took $150,000 loan, well, the advantage to the debt is that the $300,000 house is hopefully appreciating which hasn't been the case lately, but it will be going up in value the next year, it'll be worth $310,000 or $320,000 and the debt is staying the same, it's in nominal terms, it's actually decreasing in value because you're paying it down. But the $150,000 of debt doesn't increase like the value of the house, right, because that's in nominal terms but the inflation is affecting the asset. So that's why people borrow money, because there are a couple advantages to it.
And then the capital portion here is that's the investment that the shareholders are putting. When you buy stock, the company's taking that money and put it in their bank, but it's also going into capital. And the big difference between debt and equity besides what I've told you, is that debt is observable and objective, okay? Because remember, when you take a loan out, the bank is going in and looking at you and trying to evaluate what kinda risk you are, and they give you a rate so you can observe the rate and it's objective because the bank is comparing you to other people. So that rate that they're giving you is a good indication of how risky they think you are, where capital is not observable and not objective. Because you don't know... I mean, I'm investing in this company, maybe I want 10%, maybe I want 20%, and this is where it gets kinda complicated and we're not gonna go into that detail, but it's important to understand those differences.
And of course, the other thing is with capital, what are the shareholders getting? They're getting appreciation when they sell their stock and they're getting a dividend. So, you know, both have plus and minuses, but the big problem with debt is that it makes you more risky because you're saying to yourself, "Well, Bob, if debt is such a good deal, why don't I just borrow money instead of taking stockholders', you know...taking equity because the rates are obviously a lot lower than what stockholders want, you know, 6% versus 10%, 15% or 20%?" Because debt makes you much more risky, okay, and you can see that when the last downturn in 2008, a lotta companies were wiped from the face of the earth because they had high debt loads. So it's great to have debt when you're calculating weighted average cost of capital, but debt increases the risk, which means the capital that the stockholders are gonna be putting in, they're gonna want a lot more for that capital.
And, you know, if you look at companies, they spend a great amount of time figuring out what the balance should be between debt and capital. If you look at pharmaceutical companies, they don't usually have a long-term debt, and why is that? Because the pharmaceuticals company sales are like this, they have a product, they make a lotta money, it goes off patent, it goes down. You know, they don't want that risk on their balance sheet, and they have good cash flow, so usually they don't need it. But some industries and some professions, you don't want debt because when things go down, you're not gonna be able to make the debt payment, and guess what, stockholders don't get paid, right? The debtholders do get paid usually, you know? So, you know, they have got claim on the assets just like the house we talked about, they have a claim on the house. So there's an interplay between capital and debt that you have to...we...you know, as a valuation expert, we have to really have a good understanding and calculate the effect.
But let's just give you a couple quick examples here. You know, stockholders invest in the company because they believe that they will...that, you know... Why do they do that? Why do they invest? Because they believe they're gonna get a dividend and capital appreciation that will exceed the bank that the rate gives. You know, the bank...like, the bank will give 'em three and a half percent. Well, maybe they want 11%, so they'll invest in a company, you know, and hopefully they'll get their 11%. Banks will loan money to companies because they will earn more than they're paying their customer. This is obvious. What are you getting in the banks now? Well, you know, one tenth of 1%, but if you go to take a loan, they're gonna charge you six. That's six to one, that's a lot, okay? So they're willing to lend at a lower rate than a stockholder would want because they're borrowing at a much lower rate. And then, you know, banks pay, you know, 3% on CDs and low money at 6%, so, you know, basically there's 100% profit here, but it's a lot more because you go to any town, the nicest building in a lotta towns is the bank. And why is that? Maybe the post office sometimes is second or third, a library, but the reason the bank is one of the nicest and has the best location is because the rates they're earning are pretty impressive, especially now.
So let's just do a simple example here. Capitalization rate for equities 11%, debt is 3%. Remember, the debt is a lot...the rate on the debt is a lot more than the stockholders would expect. So what is the weighted average cost of capital that I would use for this company? Well, it's 11. Let's assume that the equity was a $1,000 and the debt was $1,000, we just weight those, in this case, it's 1 to 1, so it's 11 plus 3 is 14. I would take half. My capitalization rate is 7%. Now if I got rid of the debt, it would be 11%, if I got rid of the equity, it would be 3%. But remember, debt is not a free ride, okay? If I increased the debt to, like, $10,000 instead of $1,000, well the cap...the equity investors would want a lot more than 11% because now it's a much more risky company.
So that's a brief overview of cost of...of weighted average cost of capital. If you have any questions on this video, feel free to give me a call or email me.