- We are now ready to talk about
the important topic of the weighted average cost of capital,
or the WACC.
As we have seen, a company's capital structure
determines how costly it is to obtain external financing.
Let's consider Lily's case three,
where Lily gets half of her financing from lenders
and half of her financing from investors.
The weighted average cost of capital is then
just the average of the cost
of those two sources of financing.
5% for the lenders, 17% for the investors.
The weighted average cost of capital is computed
by just putting those two together
with half weight on each one of them.
The average is 11%.
The weighted average cost of capital tells a company this:
What does it cost us to get money?
And then the company uses that WACC number
to evaluate the attractiveness of various projects.
We can compute the weighted average cost of capital
in each one of the four Lily capital structure cases.
100% debt, 100% equity,
50/50 debt and equity,
and 90/10 debt and equity.
In each case, the weighted average cost of capital
is computed as the cost of the debt
multiplied by the fraction of the financing
provided by the lenders, plus the cost of equity,
multiplied by the proportion of the financing
provided by the investors.
In this case, we see that case three,
the 50/50 split provides the lowest
weighted average cost of capital of 11%.
You can think of the whole purpose of capital structure,
and finding the optimal capital structure
as being to find the capital structure
that will give a company
its lowest weighted average cost of capital,
its lowest WACC.
If your cost of capital is lower,
that means there are a greater number
of attractive projects out there.
If my cost of capital is just 11%,
I can find many more attractive projects
than if my cost of capital is 15%.
The objective of corporate finance and capital structure
is to find the capital structure
that will provide the lowest
weighted average cost of capital, the WACC.