Unveiling the WACC—Why It Matters in Decision Making

#FinanceSimplifiedWithCFORicardoMartinez

Hello once again, LinkedIn Community!

Welcome to the third installment of our series #FinanceSimplifiedWithCFORicardoMartinez

After exploring Working Capital and Budgets, let's delve into a slightly more intricate topic today: Weighted Average Cost of Capital, or WACC for short.

?? What is WACC? WACC represents the average rate a company is expected to pay to finance its assets. Think of it as the interest rate you pay on the "loan" that is your business. WACC considers various financing sources, such as debt and equity, and weighs them according to their proportions.

?? Why is WACC Important? WACC is a critical number because it helps companies decide whether an investment is worth making. It is like a financial compass guiding where to allocate resources for the best return.

?? Understanding WACC through Examples

Example 1: Startup Financing ??

Debt: $200,000 at a 5% interest rate

Equity: $300,000 with an expected return of 8%

WACC = (Debt/Total Capital) x Cost of Debt + (Equity/Total Capital) x Cost of Equity

WACC = ($200,000/$500,000 x 0.05) + ($300,000/$500,000 x 0.08) = 0.02 + 0.048 = 0.068 or 6.8%

Example 2: Expanding Your Coffee Shop ?

Debt: $50,000 at 4% interest rate

Equity: $150,000 with an expected return of 7%

WACC = ($50,000/$200,000 x 0.04) + ($150,000/$200,000 x 0.07) = 0.01 + 0.0525 = 0.0625 or 6.25%

Example 3: Manufacturing Plant Upgrade

Debt: $1,000,000 at 6% interest rate

Equity: $1,000,000 with an expected return of 9%

WACC = ($1,000,000/$2,000,000 x 0.06) + ($1,000,000/$2,000,000 x 0.09) = 0.03 + 0.045 = 0.075 or 7.5%

?Wrap-up WACC is an essential tool for decision-making in business.

It is the rate you effectively pay to keep your business running and should be the minimum return you accept when considering an investment.

Do you have any questions about WACC or other finance topics you'd like to see covered?

Please drop a comment below or send me a private message.

Stay tuned for our next chapter in the #FinanceSimplifiedWithRicardoMartinez series!

Best wishes, Ricardo Martínez