Understanding Cost of Debt and Calculating WACC with an example — Transcript

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1. 0:00the cost of debt is simply the yield to
2. 0:03maturity on the current debt the company
3. 0:06owes now yields maturity is just a very
4. 0:08fancy way of saying pretty much the
5. 0:10interest rate and for our work we're
6. 0:12going to say it's the exact same just
7. 0:13because the differences are so small
8. 0:16it's not really worth diving into and it
9. 0:17takes a long time to explain if you
10. 0:19truly want to know you can google it i'm
11. 0:22just going to tell you that the interest
12. 0:23rate is a lot easier for a way to think
13. 0:25about it so the interest rate on your
14. 0:27debt is really the cost of debt boom
15. 0:29that was so much easier than cost equity
16. 0:31right okay but figuring out the cost of
17. 0:34equity and the cost of debt once again
18. 0:36only about half the equation you see
19. 0:38whack starts with the word weighted
20. 0:40which means that for every company
21. 0:42there's a certain weight between equity
22. 0:45and debt see some companies going to
23. 0:47have 90 equity other companies gonna
24. 0:48have 50 equity that's why you have to
25. 0:50look at each one underneath the total
26. 0:53financing of the company so let's dive
27. 0:55into our example one more time and
28. 0:57really hammer this out okay do you
29. 0:58remember our entertainment company that
30. 1:00we did the cost of equity for just a few
31. 1:02minutes ago you know it had four million
32. 1:04dollars in debt and had five million
33. 1:06dollars in equity and well i didn't add
34. 1:08this part we're gonna add it right now
35. 1:10we're gonna say that last year it paid
36. 1:12400 000 dollars in interest so let's
37. 1:14figure out the cost of debt first well
38. 1:16the cost of debt is really just the
39. 1:18interest rate easiest way to find the
40. 1:19interest rate is divide the amount paid
41. 1:22in interest by the total debt so for
42. 1:24this situation it'd be 400 000
43. 1:27divided by 4 million and that just gives
44. 1:29us 10
45. 1:30not too bad now what we have to find out
46. 1:32is what proportion of their capital is
47. 1:35equity and what proportion of it is debt
48. 1:38so all we have to do there is do four
49. 1:40million dollars in debt divided by four
50. 1:42million dollars in debt plus
51. 1:44five million dollars in equity now we
52. 1:46have to the exact same thing with equity
53. 1:48which is five million dollars in equity
54. 1:49divided by four million dollars in debt
55. 1:51plus five million dollars in equity as
56. 1:54you can see all we're doing here is just
57. 1:55taking each portion the percentile of
58. 1:58the total that debt and equity make up
59. 2:01not too complicated so we see that debt
60. 2:03makes up 44
61. 2:05of their total capital and equity makes
62. 2:07up 56 of their total capital now we know
63. 2:10everything we need to do to fully
64. 2:12calculate whack so i actually have not
65. 2:14given you the exact equation for whack
66. 2:15yet and that's because i wanted to cover
67. 2:17a few of these topics before we did that
68. 2:19but now i think you're ready you see
69. 2:20whack is just equal to the cost of
70. 2:23equity times the proportion of the
71. 2:25capital that equity is plus
72. 2:28the cost of debt times the proportion of
73. 2:30debt in the capital structure times the
74. 2:33tax shield the only difference between
75. 2:35the equity side and the debt side of the
76. 2:37wac equation is that the debt has that
77. 2:40tax shield now we talked about the tax
78. 2:41yield earlier kind of using income taxes
79. 2:43as an example and so hopefully you
80. 2:45remember that aspect if you don't we're
81. 2:47gonna go over it one more time as we do
82. 2:48this example so let's continue on down
83. 2:51this road we know that our cost of
84. 2:52equity was around 9.7 percent we
85. 2:55calculated that when we did cap m
86. 2:56earlier on this entertainment company
87. 2:58and now we know that our proportion of
88. 3:00capital that is equity is right around
89. 3:0256
90. 3:03so all you have to do is calculate 9.7
91. 3:06percent times 56 percent and we get 5.4
92. 3:10percent that's the half of whack that is
93. 3:12from equity now let's do the debt half
94. 3:15the easiest way to do this is to start
95. 3:16with the tax shield remember the tax
96. 3:18shield is just one minus your tax rate
97. 3:21our tax rate was 30 percent but we found
98. 3:23that out and we used that number when we
99. 3:25leveraged up a beta when we did cap m so
100. 3:28one minus 30
101. 3:30is 70
102. 3:31so all we have to do for the debt side
103. 3:33of the equation is multiply our 10
104. 3:35percent in interest payment that we make
105. 3:37every year we calculate that earlier
106. 3:39times the 44 that debt makes up of the
107. 3:42capital structure times our 70
108. 3:45that gives us 3.1 percent and that's the
109. 3:48debt side of the equation so now we have
110. 3:50those two numbers we just add them
111. 3:52together and our weighted average cost
112. 3:54of capital for entertainment company
113. 3:56is 8.5
114. 3:58boom there you go so what does this mean
115. 4:01well this tells us that in order for us
116. 4:03to borrow a dollar we should expect to
117. 4:05pay eight point five percent on that
118. 4:07dollar so if i borrowed a hundred
119. 4:09dollars within one year i should be
120. 4:11prepared to pay that person back
121. 4:13wherever i took the money from 108.50
122. 4:16just because as a company that's how
123. 4:18much it costs us to borrow money or
124. 4:21capital so the weighted average cost of
125. 4:23capital just shows you how much money
126. 4:25should you expect to pay back someone in
127. 4:27the future based off of your company
128. 4:29today now for artwork we're going to use
129. 4:32this number as a discount rate remember
130. 4:34how i talked about using discount rates
131. 4:35with npv and irr and how sometimes are
132. 4:38made up and sometimes are given to us by
133. 4:39their bosses and sometimes we have to do
134. 4:41it ourselves well whack is how a lot of
135. 4:43companies calculate their interest rates
136. 4:45so that they can best and most
137. 4:47accurately value investment
138. 4:49opportunities using mpv and irr and
139. 4:52tools like that so now that we know how
140. 4:53to run with wac we have a lot better
141. 4:55grasp of how companies actually use this
142. 4:58and npv and irr to make decisions now i
143. 5:01know this is a very very long video
144. 5:03hopefully you've stuck with us all the
145. 5:04way to the end if you have you've
146. 5:06learned whack and whack is invaluable
147. 5:08you see you also learned a few great
148. 5:10tips along the way you probably didn't
149. 5:11realize you learned that whack changes
150. 5:13throughout time changes because of your
151. 5:16beta changes your industry just may go
152. 5:18in and out of favor the risk-free rate
153. 5:20changes the market return changes all
154. 5:22those kind of things changes your debt
155. 5:24to equity ratio that's going to change
156. 5:26too and what you'll find out later on in
157. 5:28these videos is that the more debt you
158. 5:30use is usually actually negative when it
159. 5:32comes down to calculating whack and that
160. 5:34means that whack gets a lot lot bigger
161. 5:36you see you want whack to be low low
162. 5:38whack means that people are willing to
163. 5:39give you money for less in return which
164. 5:41means that you as the owner get to keep
165. 5:43more money yourself so let's go into the
166. 5:46next set of videos and talk a little bit
167. 5:47more about how to leverage these ideas
168. 5:49that we've worked on today
169. 5:51into some real life examples