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Let's say you need money to do business... this is called capital. However, where do you get this capital? You get it from either the owners' money (equity) or you get it from borrowing from the bank or other sources (debt). [ Ссылка ] If your capital is borrowed from the bank, does this have a cost?
Yes! It's the interest on your loan. So if the interest rate is 5%, then your cost of capital is also 5%. But if your capital comes from investors instead of a bank loan, does this have a cost?
Yes! It's the expected return of your investors. If investors are expecting a 10% average return by investing with you, then your cost of capital is 10%. It's called a "weighted" average because it gives more "weight" or importance to either your borrowed capital or your investors' money, whichever is greater. Now here comes our problem...
What if part of your capital comes from bank borrowing at 5%, and another part of your capital comes from investors expecting 10%?
Is your cost of capital 5% like the bank loan or 10% like the investors' expected return?
Of course, it's something in between... but not exactly in between because you might have more of one than the other.
Check out my free video and also download my free WACC cheat-sheet at MBAbullshit.com . See ya there! (Note, we are different from Investopedia)
