August 2020 - 31

MANAGEMENT
WACC
= ((Debt ÷ Total Capital
x Cost of Debt)
x (1 - Tax Rate))
+ (Equity ÷ Total Capital
x Cost of Equity)
Cost of Debt
= Total Interest Expense
÷ Total Debt
ROIC
= NOPAT÷
Invested Capital
TECHNICALS
The first step in making
wise investment decisions is
understanding your cost of capital
and return on invested capital
(ROIC). That is, how much does it
cost you to use debt and/or equity
capital? And how much do you earn
by using that capital? An investment
is only worthwhile if your ROIC is
greater than your cost of capital.
Understanding these numbers will
help you make wise - and timely -
capital expenditure decisions.
Your cost of capital is determined
by your capital structure, which
is the mix of debt and equity your
company employs. Therefore, you
can determine your cost of capital
by determining your cost of debt
and cost of equity, then weighting
those costs by the percentage of
debt versus equity employed by your
business. The formula used to do this
is called the Weighted Average Cost of
Capital (WACC).
If you know your cost of debt
and cost of equity, calculating your
WACC is simple. The formulas for
determining your cost of debt and
cost of equity depend on whether
your company's debt and equity is
private or public. For this exercise,
we will assume both debt and equity
are private. To determine your cost
of debt, divide your total interest
expense by your total debt.
Determining your cost of equity
is more complicated. For public
companies, the cost of equity is
estimated using the capital asset
pricing model (CAPM). Private
companies can adjust the CAPM
to determine their cost of equity
but we suggest using an alternative
approach.
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Think about your cost of equity
as the return required for you
to invest in your business. For
example, if you expected a 5%
return on equity you invested
in your business, would you
invest? What if you expected a
10% return? How about 15%?
The return at which you say,
" Yes, I would invest " is your cost
of equity. If your business has
multiple equity investors, you
also need to determine the return
at which they would invest.
After calculating your WACC,
you need to determine your
ROIC. To do this, divide net
operating profits after tax
(NOPAT) by invested capital. If
your resulting ROIC is greater
than your WACC, the investment
is worth considering.
Other factors that must be
considered are cash on hand,
cash burn rate, the option
value of money and operating
leverage.
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GREENHOUSE PRODUCT NEWS 31
http://www.growwithpeters.com
August 2020

Table of Contents for the Digital Edition of August 2020
