Thursday, March 22, 2012

Weighted Average Cost of Capital

WACC: Weighted Average Cost of Capital
WACC tell us how much a company is paying on average for its financing, typically borrowed money.

Debt: $1,000 @ 12% = $120
Preferred Stock $1,000 @10% = $100
=  $220 / $2000
WACC = 11%

Why calculate WACC?
WACC is just used to show our average borrowing costs before we make an investment.

WACC = 11%
We can invest in a new machine. The machine costs $1,000,000 and it will make $50,000 per year.
ROI = 50,000 / 1,000,000 = 5%
WACC = 11%.

- If you need new machines, consider the cost of capital.

You must make a higher return on investment (ROI) than WACC to make money. If the WACC is higher than the ROI, it's a bad investment. Many public companies make investments with WACC higher than ROI.

Huh? Why would a public company make a guaranteed losing investment?

Very simple. The hype around the acquisition will sometimes make the stock rise despite the guaranteed losses from the investment. As well, when the company goes bankrupt, the CEO and friends can buy the company for cheap.

Example 1: Buying a Rental House
The average house in Canada costs $372,000 and it rents out for $1,200 per month, so $14,400 per year. Annual maintenance is $3,000 and annual interest rate is 5% (long term mortgage).
House price $372,000
Rental Revenue: $14,400
ROI = 3.87%
Interest cost: $18,600
Maintenance: $3,000
WACC = 5.80%
This investment loses money.

Example 2: Starting a Mine
The mine costs $100,000,000 and it will produce approximately $10,000,000 in annual profits. The cost of a loan to buy the mine is 7%. It takes 6 years to get the mine running and it will produce ore for 40 years.
Cost of mine $150.07M
6 years of interest = $50.07M
40 years of profit = 400M
40 years of interest = 420.196M
LOSS over the 46 years =20.196M
ROI = - 0.31%
This investment loses money because of the waiting period of starting the mine

- Borrowing money to do business can be expensive and end up in the bank taking the assets.

Example 2: Buying a Manufacturing Company
The company is for sale a $100,000,000 and it is expected to make $15,000,000 per year. Cost of capital is 8%.
Cost of  company: $100m
Annual profit = $15M
ROI = 15%
WACC = 8%
This investment makes good profit. ROI is greater than WACC.

-Buying a good manufacturing company might work.

In next article we will do more examples of how to calculate WACC instead of getting totally off track like we did in this article.

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