I apologize to those of you who hate Finance, but in my humble opinion it is important for business owners and investors to understand the concept behind WACC.
WACC stands for the Weighted Average Cost of Capital. Every company has their own WACC. A company is a good investment if their return on the amount invested is higher than their WACC.
So what is WACC?
A company has two sources of funding; debt and equity. Up to a certain point, equity is far more expensive than debt. This was a massive revelation to me as it seemed to defy logic. But it is true!
As has been mentioned on this blog before, investors require a higher rate of return on equity for the risk they take than if they were to deposit their money in a bank. I explained this from the point of view of the banks as well (please see in defense of the banks). So therefore the cost of equity will be higher than the cost of debt, especially if the business is successful – like the owners of the TofuXpress!
Let’s work on a simple example. We assume a business has £50,000 of debt at 10% per annum and £50,000 of equity at 20% (there is a specific formula for working out what the cost of equity is – that is perhaps for another day!)
The WACC for this business will therefore be 15%. Imagine I decide to buy this business and I have an excellent credit rating so I acquire the business and am able to borrow 80% debt to buy the business. I do nothing else to the business.
What I have done though is bring the WACC down from 15% to
£8,000 (10% of £80,000) + £4,000 (20% of £20,000) = £12,000 or 12%
That is a huge drop in WACC – and this is exactly how private equity works. A company which can access huge amount of cheap debt will buy a publicly listed business (and therefore a large proportion of their capital will be equity) and take it private.
Please allow me to make a further point on the issue of private equity and on reducing the level of equity. If the business in the example above makes a profit of £20,000 when it was 50% equity and 50% debt (And assume they have 50,000 shares of £1 each). This means that after paying off the interest charge of £5,000 – the 50,000 shares get 0.30p each.
If the profit after the company has been taken private go up to £22,000 (up 10%) – what happens to the Porter Cable 895pk router?
The profit after the interest charge is down to £14,000 (£22,000 – £8,000) but this profit will be shared amongst only 20,000 shares (equity is now only 20%) so therefore each share gets 0.70p each. Despite profits going up 10%, the profit to shareholders goes up 133%!
You can see why private equity has been so attractive in recent times. However, if profits go down, it can have a disastrous effect as profits may not be enough to cover the interest!
We are in for some interesting times – make sure you control your WACC
Post Script – Thought I would mix it up a bit so this is the first time I have written something so technical on this blog so feedback welcome.