Economic Concepts III

Cost of Capital...

What is Your Cost of Capital?

If I were to walk up to you and ask you "So what do you think your WACC is?"  You might call 911 and have me institutionalized.  I would not blame you.

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It is actually a very important question and concept.  What is your cost of capital?  How much capital are you tying up in your business?   Is your business actually earning back the capital employed?

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Businesses tie up two sources of capital.  The first is debt (loans, leases, credit cards).  The second is equity (stock, preferred stock).  Debt is generally the other guy's money.  Equity is your money.

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Almost every company has a combination of debt and equity employed to run the business.  Take a look at the calculations on the right.

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The company has a list of debt and the underlying base of equity as well.  The company has a total of $6 million in total capital tied up at various rates.

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So the calculation is pretty straightforward.  Take the blended cost of the debt items at the various rates and the rate of return the owners would like to see on their capital and you get the WACC.  Weighted-Average Cost of Capital.

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Why does this matter?  YOUR RETURN ON ASSETS MUST EXCEED YOUR COST OF CAPITAL OR YOU ARE LIQUIDATING YOUR BUSINESS.

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Take a look at this calculation.  It is important.  Long-term a company cannot survive if it does not produce a return on assets exceeding the total cost of capital.  It might make it a few years or even decades, but it will fail.

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The company has net income of $350,000 on an asset base of $6,000,000.  The company missed on the ROA exceeding cost of capital.  It has a performance gap.

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It needs to raise revenue, cut costs, sell some assets, or improve margins.

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What it your WACC?  What is your return on assets?  Are you covering your cost of capital?  How many years have you missed this target?  Perhaps most importantly, what are you going to do to right the ship?

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