|Weighted-Average Cost of Capital|| |
Synonyms: Cost of Capital
Weighted average is an adjective that refers to a manner to calculate the average for a total amount, where you add the averages for several components with approprite weighting. In this context the adjective sounds intelligent albeit it seems like surplusage to us.
The company must be able to pay the cost of capital from its profits, so one should consider cost of capital as equal to a hypothetical minimum rate of profitability that would be sustainable or the minimum profit that the company needs to earn in order to make its necessary payments to investors. Businesses that do not return the minimum profitability to sustain their capital structures can go into default, which is a desperate situation, unless and until they receive new investments or higher profits.
Cost of capital is an interesting measure to be familiar with. For example, if a company pays 10% per year on its loan which is 10% of total capital, and it pays nothing to its stockholders who contributed 90% of total capital, weighted-average cost of capital is 1% annually. If a company's profits allow it to pay its cost of capital, all is well. If a company has further profits after paying the cost of capital, it can re-invest in the business or make distributions to owners.
The prefatory term of weighted-average is a powerful term where it signals a true combination of dual or multiple components, parts of a whole, and produces a homogenized total rate that is on a per dollar basis. Costs of capital are frequently presented about and discussed, of equity and of debt side by side, and in that context weighted-average can be proper.
Capital costs naturally lend themselves to being described in terms of percentages. Loan interest obligations for the whole year are more-or-less a percentage rate multiplied by the principal. There can be multiple sources of capital, and each would have an associated cost in terms of annual interest rate, and equity capital does not necessarily have any cost but certainly it can and in many cases does have associated cost. In planning a capital structure, one can project the cost of receiving additional outside capital. In an exercise of self-discipline, a company can consider whether its profit on re-investing the after-tax profit is greater than its cost of capital and reduce its capital its its organically generated profits do not exceed its cost of capital.
To allow the cost of capital to be compared between the capital which is debt and the capital that is equity, or compared among alternative sources of capital, the cost of capital is looked at in terms of the average cost per dollar of capital.
Cost of capital is the cost that an entity incurs in order to have the right to use the capital (money). If teh capital is equity and the capital investors receive dividends, there is a cost of equity. One naturally might use a weighted-average by beginning with a series of costs that are expressed as a percentage of a capital amount and weight them according to capital amounnt, expecially where the rate stays teh same and teh balance changes daily.
Accordingly each category of capital has a cost per year that can be expressed as a percentage of the average amount outstanding in the year. "Weighting" may refer to adding the absolute amount of capital outstanding each day during a period and dividing by the number of days in that period to obtain the average amount over the period and then multiplying by the periodic rate.
To more directly conceptualize the cost of teh average dollar of capital, assuming the data is available, the total of the equity capital cost and the debt costs (after subtracting any tax benefits) can be added up and divided by the average balance of total capital, instead of combining the weighted averages, to deterine the average cost per dollar of capital for the period.