Finance: What is a WACC Model?

WACC is an acronym for weighted average cost of capital. A company can raise money either through selling equity or by raising debt. When measuring equity, it is essentially the amount of money a company needs to make to keep shareholders from selling. In the case of debt, it is the cost of the principal and interest, along with payment terms, which can constrict cash flow. WACC is a calculated estimate that analysts often use. Ironically, the higher a stock price rises, the greater the cost of equity capital, as shareholder expectations are reset at a higher bar.

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Transcript

00:25

run the famed charcoal smoker producer grills grills grills or

00:31

grilles Cubed is matthew people like you said and you

00:33

want to buy We've got gas The finest purveyor of

00:37

propane grills on the market which will help grills Grilled

00:41

grills rule the outdoor barbecue market no matter what their

00:44

customers Fuel of choices Well you need to borrow a

00:47

ton of money to buy out your competitors A billion

00:50

dollars worth of borrow in fact it's so much dough

00:53

that you have to borrow it from three different places

00:57

Well the money you're borrowing is the capital You need

01:00

to buy your target We've got gas That's your target

01:03

Okay capital c and wacker at least one Well the

01:07

bank demands that the bank comes first in priority Should

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things you know go awry and you go the b

01:14

word Yeah Bankruptcy We we don't like to say that

01:17

too loudly Run banks Okay well the bank will loan

01:20

you two hundred million dollars and we'll charge you five

01:22

percent interest on that money That five percent is your

01:25

cost of capital from that bank lender for funding round

01:29

number two while you turned a sweet and beatrix who

01:33

in addition to being a killer grill meister in her

01:36

own right Well she also happens to be loaded So

01:39

anti b agrees to loan you the second traunch of

01:42

money and we'll come in second in priority behind the

01:45

bank in collecting her dough Should you know the b

01:48

word happened She'll own you seven hundred million at seven

01:52

percent interest Great So now you only have to raise

01:55

your last hundred million box and it has to come

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third in the priority stack up of collecting Should things

02:01

go you know awry With no other options you hit

02:04

up tony mafia ony the shadiest loan shark on either

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side of the mason dixon So you pay your respects

02:10

you know just the glove with tongue and things get

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a little weird But somehow at the end of the

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day you walk away from tony's headquarters with a wallet

02:19

full of cash as your stomach is full of non

02:22

amalfi onis sunday raghu what That last hundred million box

02:26

comes with a very high interest price Twelve percent So

02:31

when the tony notes ironically that quack is the same

02:34

noise that baseball bats make when they hit knees when

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will you pay attention And you do the math keenly

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aware that the waiting's here are very different looks like

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this and that the huge middle traunch of seven hundred

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mil it's seven percent has the biggest effect on your

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cost of capital because well it's a big fat seventy

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percent of the total amount you're borrowing Well the first

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two hundred mill is cheap at five percent and it

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costs you ten million bucks here to rent that money

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The second trunk of seven hundred million is kind of

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sort of mad sheepish at seven percent and it costs

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forty nine mil a year to rent and that last

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traunch of one hundred mil is super expensive for what

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you're getting costing you twelve million a year to rent

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So you add up the capital rental costs of ten

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plus forty nine plus twelve and you get seventy one

03:21

million box to rent a billion dollars for this transaction

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that seventy one mil to rent a bill and pay

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that runs So what is your whack or weighted average

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cost of capital Well seventy one million over a billion

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or seven point one Percent The black models always percentage

03:40

Some companies will use their stock to buy a competitor

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er rather than using cash But that's not always the

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case and calculating the cost of equity is way more

03:49

complex and involves a lot more smoke and or mirrors

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So we're just doing debt here people and there you

03:54

have it Whack in a nutshell But you know what's

03:57

not whack shmoop snu finance themed hip hop album on

04:00

sale soon coming soon to a itunes thinking you're you 00:04:04.93 --> [endTime] yeah we'll eat your heart out there hamilton