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We've all heard those terms before...capital, equity, rates and premiums. But what the heck do they even mean??
Cost of Capital
Everything in Finance-- especially in the fund space-- comes down to your Cost of Capital.
What is the Cost of Capital?
In the investment world - Cost of Capital refers to the blended cost of both debt and equity financing.
The Weighted Average Cost of Capital (WACC) is commonly used in various valuation methods to determine what your capital is actually costing you. Take a look at how it is calculated:
Now, let’s first break down the Cost of Debt.
Cost of Debt
How do we decide how much debt should cost?
The cost of debt is essentially the interest rate that a company or entity pays on its debt obligations. Just like you have a mortgage rate on your home, companies & funds have different rates on the lines of credit that they hold.
You average out the interest expense on those loans and multiply that by your tax shield.
Again- Just like on your home mortgage, where you get a deduction on your taxes… companies also get a tax shield or tax deduction for the amount of debt they have.
Cost of Equity
The Cost of Equity is most commonly calculated using the Capital Asset Pricing Model (CAPM)
The equation for CAPM = Risk-free Rate + (Beta * Market Risk Premium)
Risk-free Rate : We already talked about the Risk-free Rate. Find it here.
Beta: The beta is a little more difficult to calculate. It is most commonly used for public securities, but it can also be calculated for private investments.
In its simplest form, the beta is measuring how correlated the investment is to the markets- or the economy in general.
If you are calculating the beta of a private company, you will usually just take an industry beta.
Some companies are more volatile than the markets/economy resulting in a high beta.
In contrast, some companies are less volatile than the markets/economy, resulting in a low beta.
<0: Negative beta : Inversely correlated with the markets
<1: Low beta : Less volatile than the markets
=1 : Market beta : Perfectly Correlated with the markets
>1 : High Beta : More volatile than the markets
Market Risk Premium = (Historical Market Return - Risk Free Rate)
If the market return is historically 10%, and the Risk Free Rate is 1%... than your Market Risk Premium is 9%. In other words, you are getting a premium of 9% by investing in the markets. Not too difficult, right?
Now, to get your WACC, you need to figure out what your debt-equity ratio is. If a company is made up of $80,000 of equity and $20,000 of debt.
$80k/100k = 80%
$20k/100k = 20%
Weighted Average Cost of Capital = (20% * Cost of Debt) + (80% * Cost of Equity)
Me and my team members have produced content- Private Equity Modeling Videos and DCF Videos- that both explain a little bit more about the WACC.
Finance doesn't have to be scary and overwhelming! But in order to be a successful fund manager, understanding it can make all the difference.
If you have more questions for me or anyone of my team members, be sure to join my free webinar here.
Thanks for the read!
