A company uses two main methods to raise money to do all the stuff companies do, like buy machinery, purchase break room snacks, and import illegal fireworks for the Fourth of July company picnic.
To get the cash for this stuff, companies can borrow, or they can sell equity. Borrowing involves getting money through a loan. Selling equity means you find investors who buy a portion of the company in exchange for cash. Loans have the benefit that the owners of the company don't have to dilute their stakes in the firm. They get to stay in charge. They just have to make the regular interest and principal payments. However, selling equity has its upsides as well. Mostly, the company doesn't have to pay back the funds. The investors take a risk that the company will earn profits in the future. If it goes bust, they lose the investment.
The traditional theory of capital structure describes the ideal mix of borrowing and equity. Since owners have an interest (literally) in preventing their holdings in the firm from getting diluted, they have a tendency to rely on borrowing. It's like building your business with someone else's money.
However, the traditional theory of capital structure says there's a limit to this strategy. It states that, at a certain point, too much borrowing puts a cap on a firm's value.
That extra money coming in from the additional loans doesn't do anything to build the owners' fortunes, because the company becomes overleveraged. This situation caps the upside potential of the firm. Therefore, companies should strive to find an optimal mix of equity and debt to build their business.
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Finance: What is a WACC Model?18 Views
Finance allah shmoop What is a lack model That's whack
Yeah it is people We had to go there once
okay we're done Quack stands for weighted average cost of
capital and whoa yeah that's a mouthful heavy term but
the concept's pretty simple All right Well let's say you
run the famed charcoal smoker producer grills grills grills or
grilles Cubed is matthew people like you said and you
want to buy We've got gas The finest purveyor of
propane grills on the market which will help grills Grilled
grills rule the outdoor barbecue market no matter what their
customers Fuel of choices Well you need to borrow a
ton of money to buy out your competitors A billion
dollars worth of borrow in fact it's so much dough
that you have to borrow it from three different places
Well the money you're borrowing is the capital You need
to buy your target We've got gas That's your target
Okay capital c and wacker at least one Well the
bank demands that the bank comes first in priority Should
things you know go awry and you go the b
word Yeah Bankruptcy We we don't like to say that
too loudly Run banks Okay well the bank will loan
you two hundred million dollars and we'll charge you five
percent interest on that money That five percent is your
cost of capital from that bank lender for funding round
number two while you turned a sweet and beatrix who
in addition to being a killer grill meister in her
own right Well she also happens to be loaded So
anti b agrees to loan you the second traunch of
money and we'll come in second in priority behind the
bank in collecting her dough Should you know the b
word happened She'll own you seven hundred million at seven
percent interest Great So now you only have to raise
your last hundred million box and it has to come
third in the priority stack up of collecting Should things
go you know awry With no other options you hit
up tony mafia ony the shadiest loan shark on either
side of the mason dixon So you pay your respects
you know just the glove with tongue and things get
a little weird But somehow at the end of the
day you walk away from tony's headquarters with a wallet
full of cash as your stomach is full of non
amalfi onis sunday raghu what That last hundred million box
comes with a very high interest price Twelve percent So
when the tony notes ironically that quack is the same
noise that baseball bats make when they hit knees when
will you pay attention And you do the math keenly
aware that the waiting's here are very different looks like
this and that the huge middle traunch of seven hundred
mil it's seven percent has the biggest effect on your
cost of capital because well it's a big fat seventy
percent of the total amount you're borrowing Well the first
two hundred mill is cheap at five percent and it
costs you ten million bucks here to rent that money
The second trunk of seven hundred million is kind of
sort of mad sheepish at seven percent and it costs
forty nine mil a year to rent and that last
traunch of one hundred mil is super expensive for what
you're getting costing you twelve million a year to rent
So you add up the capital rental costs of ten
plus forty nine plus twelve and you get seventy one
million box to rent a billion dollars for this transaction
that seventy one mil to rent a bill and pay
that runs So what is your whack or weighted average
cost of capital Well seventy one million over a billion
or seven point one Percent The black models always percentage
Some companies will use their stock to buy a competitor
er rather than using cash But that's not always the
case and calculating the cost of equity is way more
complex and involves a lot more smoke and or mirrors
So we're just doing debt here people and there you
have it Whack in a nutshell But you know what's
not whack shmoop snu finance themed hip hop album on
sale soon coming soon to a itunes thinking you're you 00:04:04.93 --> [endTime] yeah we'll eat your heart out there hamilton
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