Weighted average cost of capital

In Figure 1.1 the business has a pool of money, the "capital invested". To invest this wisely, the fi rst stage is to determine what the average dollar in the pool costs in terms of the return that the investors are seeking. Knowing this value enables the directors to make choices about the activities and projects they select to invest in.

For example, a business has raised $70,000 of equity capital and a $30,000 loan. If the shareholders require 20% return on their money and the bank wants 8%, the average dollar would cost the business 16.4%, which is calculated as follows:

Therefore the average cost of a dollar = 16,400/100,000 = 16.4%

This is known as the weighted average cost of capital (wacc). For a business to be successful and satisfy its investors it must earn at least this rate on its operating activities.

A combination of the two sources of fi nance provides an optimal way to raise funds and build a business. A business with debt usually has a lower wacc than one without. A low wacc can therefore create more value for the shareholders out of the projects it chooses to invest in.

This is a simplifi ed formula for the purposes of illustrating the concept. To calculate the actual returns required for shareholders and banks, the optimal proportions of each source and the effect of tax are explained in more detail in Chapter 6.