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>> Alright? All of that being said.

Â Before we start understanding the terms of the cost of capital,

Â we need to define a little bit of notation.

Â so, where are we going with this?

Â First as we said before many people simply refer to these as the WACC.

Â And the WACC stands for the weighted average cost of capital.

Â Let me make a little parenthesis here.

Â And, and sort of make the point that more often than not, when in

Â finance we call an average of something, we typically mean a weighted average.

Â And weighted basically means, taking into account how much you're using of each.

Â So, if we were to take an average of debt and

Â equity, basically we would add up the two and we divide by two.

Â But if we were to actually take a weighted average, we would

Â take into account what proportions of debt and equity a company's using.

Â And as we'll see in section four, the company that we're dealing with is

Â using a lot of equity, and using very little of debt.

Â So we cannot really just take a crude average of the cost of debt and

Â the cost of equity, when a company may be using 98% equity and 2% debt.

Â So you know, if we were to take a straight average, that would be 0.5

Â the cost of debt, and 0.5 the cost of equity, that's not what we want to do.

Â We want to take into account how much,

Â of each source of financing the company is actually using.

Â That's why we call it the weighted average cost of capital, although some people

Â simply refer to this as the WACC, and some people just take out the word weighted and

Â refer to it as the cost of capital.

Â And that's mostly what we're going to do.

Â Most people don't use the word weighted, and

Â we assume we know that it's a weighted average cost of capital.

Â So, there are three ways, or

Â at least three ways of thinking about this cost of capital.

Â One, is from the point of view of investors.

Â Remember, investors are the ones that provide the capital, so

Â the company can invest to produce the goods and services that we like to buy.

Â And investors do not provide the capital for free.

Â Capital is scarce, they could provide the capital to other companies.

Â They could provide the capital to other investments.

Â And therefore whenever they provide capital to a company,

Â they're going to require a return.

Â And as always we say in finance,a return that is required is going to

Â be a function of the risk that you perceive that you're bearing.

Â So there's going to be, as we said in sessions one and

Â two, a positive relationship between risk and return.

Â The higher the ratio perceived in the capital you invest,

Â the higher the return that you're going to require.

Â So, one way of, of thinking about the the, the,

Â cost of capital is investors are providing debt, investors are providing equity.

Â They require a return on debt, they require a return on debt, on equity.

Â And the weighted average of those required returns is basically the cost of capital.

Â So, from the point of view of investors, the weighted average cost of capital is

Â simply the weighted average required return,

Â on the capital provided to the company,

Â that the company is going to use to make investment to produce goods and services.

Â Now we can actually sort of flip the coin.

Â And by flipping the coin,

Â we basically mean looking at this from the point of view of the company.

Â When the company raises that capital, they need to deliver a return.

Â Delivering a return does not necessarily mean paying in cash, and that's why,

Â as we said before, they cost of capital is related to risk, not so

Â much in terms of cash flows.

Â There are many companies that pay no dividends,

Â that doesn't mean that the providers of equity do not require any return.

Â They may require a return that is provided,

Â in terms of capital gains other than in terms of, of anything else.

Â Now, we can also look at the cost of capital, sort of by flipping the coin.

Â And, by flipping the coin,

Â I mean that we're going to look at this from the point of view of the company.

Â The company actually raises capital, and it needs to pay,

Â quote and quote every turn, it needs to deliver a return.

Â A return again doesn't mean, that the, the cash going out of the company,

Â you can actually invest in a company that doesn't pay any dividends,

Â that doesn't mean you're not going to require a return.

Â You deliver a return in terms of capital gains, that's why, as we said before,

Â always think of their required returns, as being a function of

Â raised not as being a function of money coming out of the company.

Â But when the company raises debt,

Â when the company raises equity, they basically need to deliver a return, and

Â that return that they need to deliver is the cost for the company.

Â Well, the weighted average of those costs,

Â is once again the weighted average cost of capital.

Â So the average return required by investors, and the average cost for

Â the company, these are like two sides of the same coin.

Â And three, the most important way of thinking about the cost of capital,

Â is as some people would call the hurdle rate.

Â And the hurdle rate is a minimum required return, on the company's investments.

Â Why is the cost of capital a hurdle rate?

Â For a very simple reason.

Â Suppose that through whatever sources of financing,

Â your average cost of raising funds is 5%.

Â Well, you don't want to invest in anything that gives you less than 5%,

Â otherwise you're basically burning money.

Â So that becomes,

Â that 5% becomes the minimum return on which you're going to invest and

Â you're not going to invest in anything from which you expect any less than that.

Â So if your cost of raising funds, on average is 5%.

Â You will be investing your capital in anything that you think,

Â you expect, that is going to give you more than 5%.

Â If you think that is going to give you less than 5%, you will

Â basically be investing in something in which you expect a negative return.

Â And no company actually can do that in the long term.

Â So, eventually you're going to go out of business.

Â So that is why the cost of capital is the minimum required return.

Â That is what it costs you to raise funds, and

Â basically you don't want to invest in anything.

Â That's going to give you a return less than what it

Â costs you to raise uh,those particular funds.

Â So those three definitions of the cost of capital are important, but

Â we're going to be using mostly the third,

Â that is that once we come up this number, this number becomes a beacon.

Â This number becomes a central decision variable for

Â the company, because you don't want to invest in anything that gives your return,

Â or from which you expect that return lower than that cost of capital.

Â And, that means that, you know, when we for example evaluate a project, well, when

Â we evaluate a project, and we calculate as we're going to see in session five.

Â The internal rate of return, basically the return we expect from the project.

Â We will not invest in anything, but

Â gives me from what we expect anything less than the cost of capital.

Â So one application, typical application of the cost of capital,

Â is project evaluation in some the models to value companies.

Â And one of those methods, one discounted cash flow method,

Â is called the weighted average cost of capital method.

Â And, guess what, the discount rate in that method is precisely the, cost of capital.

Â We're not going to get into valuation, but

Â we are going to discuss a project evaluation.

Â Value creation.

Â That we will discuss in our last session.

Â Why the cost of capital is so important for value creation?

Â Well, simply because the return that you

Â get on the capital invested must beat that cost of capital.

Â At the end of the day, our definition of whether you're creating or

Â destroying value, will go through comparing the return that you

Â get from the capital invested, from the cost of raising that particular capital.

Â So, we will talk about project evaluation.

Â We will talk about value creation.

Â And although we will not talk precisely or specifically, in one

Â section about capital structure, and in particular capital structure optimization.

Â I will make a few comments that have to do, with, capital structure once we

Â calculate the weighted averages cost of capital for stats

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