1 minute read
A WACC’y milkshake in need of no formula
by PQ magazine
Jo Tuffill shakes up the WACC calculation using a performance management technique
Formulae feature pretty heavily in the ACCA FM and PM syllabi and tend to send many students into a spin with memories of dreaded school algebra lessons. Let’s face it, accountants really need to be numerical, not mathematical.
Taking FM as an example; here is one way of throwing out that WACC’y formula.
The weighted average cost of capital is basically like costing up a strawberry milkshake, you know the ones from your local coffee shop that vary in both quality and cost.
Suppose we make 100 litres of strawberry milkshake as follows:
50 litres of milk at 10p per litre
40 litres of strawberry coulis at 20p per litre
10 litres of cream at 15p per litre
Makes 100 litres so what is the cost of 1 litre?
Weighted Average Cost per litre will simply be £14.50 / 100 = 14.5p
Now if you vary the mix keeping the total quantity fixed you can manipulate the cost. Adding more milk and less strawberry coulis will push down the cost per litre, and vice versa. We know from PM mix and yield variances, that varying the mix from the standard mix, will create either a more expensive or less expensive mix. This technique can be applied to FM and calculating the cost of capital.
Here is the trick.
When asked to calculate a WACC, replace the quantity in litres with Market Values of Finance and the cost in pence with their respective % Cost of Finance
Example: Our milkshake company is financed by a total of £100m as follows:
£50m of Debt at 10%
£40m of Equity at 20%
£10m of Bank loan at 15%
What is the WACC?
Answer
FinancecapitalMarketValueCostofcapital%Cost
Debt £50m x 10% £5m
Equity £40m x 20% £8m
Bank Loan £10m x 15% £1.5m
TotalMarketValue£100mTotalCost£14.5m
WACC will simply be £14.5m / £100m = 0.145 or 14.5% Again, if you add another source of finance you will vary the mix and manipulate the WACC. Adding more debt at a lower cost of capital will push down the WACC as follows:
Equity £40m x 20% £8m
Bank Loan £10m x 15%£1.5m
Debt2£20mx10%£2.0m
TotalMarketValue£120mTotalCost£16.5m
WACC will simply be £16.5m / £120m = 0.1375 or 13.75% which is lower. So no formula required!
