If you’re a company, a hedge fund, or an individual, you’re going to be faced with the same question: is this investment worth doing? That’s the core of finance, and the question implies that there is a risk of the investment failing as well as a chance of the investment succeeding. Those two elements make up the bulk of decision making in the financial world.
On the risk side, due diligence is often your first and most important step. If, for instance, you are a company looking to expand to a new region, you need to do market research to see if that region wants your product and, if it does, whether it can afford your product and whether you’ll be able to deliver your product in a shape and form that the market wants. This all requires research in largely non-financial realms.
If that’s done and the risks look manageable with a certain investment–great, now you can do the financial work. Now you’ll need to look at the net profit margin you’ll get from that expansion–that’s the future cash flow you will get from investing in this expansion. If the net profit margin is larger than the investment, you’re good to go.
Sounds easy, right? It isn’t, exactly. Because the profits from operations won’t come immediately, and may very likely trickle over time, we need to weigh the net present value of that cash flow versus the net present value of the investment we’re making; if the latter is less than the former, we’re good to go.
This is the core of the WACC (weighted average cost of capital) formula, which you’ll probably recognize from Finance 101 courses as:
WACC = ((E/V)*Re)+((D/V)XRdx(1-Tc))
where:
E = equity market value
D = debt market value
V = E+D
Re = Cost of equity
Rd = cost of debt
Tc = Corporate tax rate
At first glance, this may look difficult, but it’s basic algebra, and a few minutes with Excel can get you some quick answers as you move around the variables. What’s more important is understanding what’s going on here, and why this formula is so powerful.
Remember that all companies are a legal fiction comprised of a capital structure, and that capital structure is largely comprised of equity (fractional ownership to owners of the company) and debt (borrowed money from creditors who have no ownership in the company). Companies can raise money by either issuing shares to new investors or borrowing money from lenders; knowing which is the right move will rely on the WACC formula.
In some cases, an expansion may be unprofitable if funded by debt but profitable if funded by equity–this is especially true of younger or higher risk companies. In such situations, however, one can lose the goodwill of current investors as their ownership is diluted–a long-term cost that this formula does not capture, which is why the WACC formula is a starting point, not a destination, in determining whether an investment is worth doing.
When you are confident that these intangibles have been assessed and addressed, and when you are confident that you have a strong model for the value of a future investment, you can then begin to use the WACC formula to begin estimating the value gained by a particular expansion. Then you can get fancy, creating alternative models with different variables based on market research, changing market conditions, or changes to the product and the launch of the product itself.
In this way to financiers produce value, by using models to provide management with a variety of options that they can then use to make informed decisions. Whether you are in corporate finance or a hedge fund, the purpose of your work is the same: to help people make the right choice based on data and analysis. The cost of capital is one input in that process, and an extremely important one.