From the course: Corporate Finance Foundations

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Weighted-average cost of capital

Weighted-average cost of capital

From the course: Corporate Finance Foundations

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Weighted-average cost of capital

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- We are now ready to talk about the important topic of the weighted average cost of capital, or the WACC, and be able to compute a company's WACC. A company's capital structure determines how costly it is to obtain external financing. Let's consider Lily's ice cream business. Lily needs $200 million to finance her project, and the project is expected to generate cash flows of $220 million. Consider the case where Lily gets half of her financing from lenders and half of her financing from investors. The weighted average cost of capital is then just the average of the cost of these two sources of financing. Assume the cost of debt financing is 5% for the lenders, and the cost of equity financing is 16% for the investors. The weighted average cost of capital is computed by just putting these two together with half weight on each one of them, the average is 10.5%. Okay, so how is Lily going to use this 10.5% number? She will compare this 10.5% cost of capital to the 10% operating return…

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