WACC explained

Weighted Average Cost of Capital, in short WACC. This seems to be one of the most intimidating concepts in finance. Fear not, this video explains WACC in an easy to understand way. We will cover: what WACC means, how WACC is used, how WACC is calculated in the WACC formula, and why the WACC formula is pseudo-science, in other words: of questionable value and potentially dangerous. What does the acronym WACC stand for? The WACC is the Weighted Average Cost of Capital. Weighted Average indicates that we are going to apply some mathematics to get the proportions right, and Cost of Capital indicates an attempt to identify the cost of various types of capital. WACC is a calculation of a firm's cost of capital in which each category of capital is proportionately weighted. The #WACC is often used to try to answer the fundamental question in life for both investors and businesses: can we create value?

⏱️TIMESTAMPS⏱️
00:00 Introduction to WACC
00:30 WACC acronym
00:58 WACC and value creation
01:58 WACC and Free Cash Flow
03:31 WACC and enterprise value
05:06 Analyst stock recommendations
05:42 WACC and NPV
06:39 WACC formula
08:23 Cost of equity in WACC
09:13 WACC and CAPM
10:47 WACC/CAPM limitations

So how does the infamous formula work to calculate WACC? Here’s the simplest version of it, assuming just two classes of capital: debt and equity. Weighted Average Cost of Capital equals the market value of a firm’s debt divided by the market value of debt and equity, times the cost of debt, plus the market value of a firm’s equity divided by the market value of debt and equity, times the cost of equity. Remember the definition of Weighted Average Cost of Capital: a calculation of a firm's cost of capital in which each category of capital is proportionately weighted. So this thing about debt divided by debt plus equity, and equity divided by debt plus equity, takes care of getting the proportions weighted. The multiplication is with cost of debt in the first part, and cost of equity in the second part. Let’s illustrate this with a WACC example of a fictitious company. Debt is $250 million, out of total capital of $1 billion, so 25%. Cost of debt is 4%. Equity is $750 million, out of total capital of $1 billion, so 75%. Cost of equity is 16%. Multiply, and then add up, and you get to a Weighted Average Cost of Capital of 13%. So where does this cost of debt, and cost of equity, come from? The first part is fairly easy to grasp. The cost of debt equals the interest rate that the company pays on its interest-bearing debt, minus the tax benefit of interest expense being deductible. So if the interest rate is 5%, and the corporate tax rate 20%, then the after-tax cost of debt is 4%. Then comes the more challenging part: cost of equity. At this point, I hope you’ll say “what do you mean, cost of equity? Isn’t the whole idea that equity holds no legal obligation for the firm to pay anything?” No, says the economist, you should look at the opportunity cost of the equity capital. An investor doesn’t have to invest in this company if he doesn’t want to, he could earn a return elsewhere. Cost of equity is therefore a required return by shareholders for the risk they take by investing in this specific equity. And that’s where the whole idea goes off the rails, as we start using historical statistics to predict the future, basically fitting a line to past data hoping that this has any semblance to what the future might hold.

Philip de Vroe (The Finance Storyteller) aims to make strategy, #finance and leadership enjoyable and easier to understand. Learn the business and accounting vocabulary to join the conversation with your CEO at your company. Understand how financial statements work in order to make better investing decisions. Philip delivers #financetraining in various formats: YouTube videos, classroom sessions, webinars, and business simulations. Connect with me through Linked In!

[anishg]

You sir, are a blessing to us finance and accounting students. Thank you so much

[KrysDaStar]

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[trey]

Wow. You have the entirety of principles of finance uploaded to here. Have you considered writing a textbook?

[audreywhitfieldmackenzie]

Better and clearer explanations than given me by my really good Corporate Finance professor at Business School!

[maplaf]

Thank you so much. My textbook and teacher weren't able to teach me anything this way. Nearly failed my midterm but with this I think I'll ace my final. 😁

[mizanmizan]

tysm, ive been looking forever for a video that explains it well. this one really knocks it of the park.

[FromHumbleToHospitality]

While reading for the second time “wealth of nations” something related to NPV brought me to your channel and across this video….you sir are outstanding!
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[mrmajicka]

Yet another outstanding video, which even I can understand. I can see myself ditching my MBA tutor's reading list for your videos.

[carlosmariopinzon]

I love how you explain the concepts and the examples you bring into the videos. Maybe you could consider making a course :)

[Evanrholloway]

This channel was invaluable during my MBA. You’re a fantastic educator. Thanks for your work.

Considering that WACC and DCF analysis involves assumptions that can be quite unreliable, do you think it’s still a useful model despite its flaws? Do you think behavioral economics or alternative models more accurately predict returns?

[michelsalij]

Perfectly clarified. Had to rewind a few times for clear understanding (it doesn't cross my path everyday) but yeah....'floods' happen so outcome could potentially be arbitrary.

[CapitalWorksPro]

I subscribed because I have understood all of these terms and how you're arriving at the solutions. Well done.

[melvinsimbar]

The video is all over the place but great insight if you understand/ have small knowledge prior. Good video

[thegoodkidboy]

Man calls WACC whack and the world proves his point immediately after.

[TonyMandarano]

I love that you were highlighting the probability and likelihood of unexpected catastrophic market events being materially higher than is priced in… and then boom… COVID begins one month after you uploaded. 👍

[mrbrown]

When you wish to value an acquisition, we normally apply as high as possible the discount rate (well above WACC) but the seller will push the discount rate as low as possible to get higher sale value, buyer aims to buy at lower value as possible. At the end, it will be decided by gut feeling and human relationship and other external factors that sometimes gog nothing to do with the business....because it is human that decides

[davidjimenez]

Thank you so much. You make Math so simple unlike my teacher. Please do a sink fund example. thanks.

[yassine]

Hi man,
I love you, God bless you.
You are the best finance teacher I have ever seen.
Looking forward to see more content
Have a good week :-)

[TheBerlyn]

HOPE ALL is WELL? Love your videos thank you for sharing and teaching us your knowledge. I was wondering if you can demonstrate this explanation with a company in the stock market. I have better sense when i see examples like that. Watching your NPV and IRR videos which i clearly understand led me to here to the WACC video as my curiosity struck again LOL. Thank You!

[dwitigaggar]

Woah ! You indeed are a master of storytelling ! This makes learning financial concepts so interesting !