Chapter 6. The Cost of Money: Weighted Average Cost of Capital (WACC)

Welcome back. Previously, we learned how to evaluate project returns. Today, we look at the ‘Weight of Money’—the Cost of Capital.

In business, cost isn’t just about paying interest. It’s the ==“Hurdle Rate”==—the minimum threshold a project must jump over to be viable. Let’s uncover how the Weighted Average Cost of Capital (WACC) serves as the ultimate yardstick for value creation.

1. Components of Capital: Every Dollar has a Price

Companies use a mix of Other People’s Money (Debt) and Own Money (Equity). These two have completely different pricing logics.

(1) Cost of Debt ($r_d$): The Price of Borrowing

This includes bank interest or bond yields. A critical financial advantage here is the Tax Shield.

• Interest expenses are deducted before tax, effectively lowering the cost.
• ==After-tax Cost of Debt = $r_d \times (1 - \text{Tax Rate})$==

(2) Cost of Equity ($r_e$): The Shareholders’ Share

Shareholders are on a riskier boat than lenders, so they demand higher rewards.

• We primarily calculate this using the CAPM: $r_e = r_f + \beta(r_m - r_f)$.
• It’s the “heaviest” cost because it reflects the expectations of owners.

2. WACC: The Corporate Average

Since companies use both Debt and Equity, we must weight-average them. This is the WACC.

📊 WACC Composition by Capital Structure

3. Managerial Insights: Lowering the Hurdle

WACC is the target for and the tool of a CFO.

1. Investment Benchmark: If a new project’s return (IRR) is lower than WACC, reject it. You aren’t even covering the cost of the money you used.
2. Valuation Tool: When calculating the present value of future earnings, WACC is the discount rate. Lowering WACC directly increases corporate value.

==Optimal Capital Structure==: Debt is cheaper due to tax benefits, lowering WACC. However, too much debt increases bankruptcy risk, causing shareholders to demand even higher returns. Finding the sweet spot is the art of financial management.

4. Conclusion: WACC is the Limit of Growth

Today, we learned about the invisible prices companies pay for capital. Understanding WACC means understanding that there is no free money, and every investment must outperform its cost to be worthwhile.

“WACC is both the weight class of a company and its boundary for growth.”

📚 Prof. Sean’s Selected Library

• [Corporate Finance] - Ross, Westerfield, Jaffe: The world’s top textbook containing the essence of WACC and Capital Structure theory.
• [The Value Investor] - Bruce Greenwald: Practical cases on evaluating corporate value conservatively from a cost-of-capital perspective.
• [Berkshire Hathaway Letters to Shareholders] - Warren Buffett: Insights into why Buffett prefers “capital-light” businesses with low WACC impacts.

Next time, we will explore ‘Capital Structure and Leverage’—how the mix of debt and equity physically changes a company’s profit and risk profile.