The Weighted Average Cost of Capital
“Money is a commodity. Like oil or water. And that American dollar, is the best brand there is in the world. Those of us who have it. Can make more of it. By loaning it to those who don’t.”
Julian Beck, as banker J. J. Johnstone,
Died of cancer of the stomach, two weeks before the episode aired.
Every investment, whether debt or equity, is a swap of present capital for future expectation. And because money is a commodity, these swaps occur in the larger marketplace of capital. From the investor’s perspective, the goal is the highest achievable internal rate of return (IRR) on each chunk of capital deployed.
The sponsor (capital consumer) has a more complicated problem, for the sponsor must finance not secure not just a piece of the capital required, but all of it, and each time a sponsor takes some money from one source, it narrows the range of options for other sources — and therefore increases the price of that money.
Some sources of capital won’t mix with others.
The sponsor, therefore, wants to assemble 100% financing with a goal of the lowest weighted average cost of capital.
Weighted Average Cost of Capital (WACC)
That rate which, if applied to 100% to the financing, would have the same total interest cost as the mixture of debt, mezzanine, and equity actually in place.
A simple example will illustrate: a home purchase, with 25% down, and a hard-debt first mortgage loan at 6.0%. If the home buyer figures that he could earn 10% on the down payment otherwise, the WACC is calculated as follows:
Financing Mix 1
|
Source |
Percentage |
Rate |
Net cost |
|
First loan |
75% |
6.0% |
4.50% |
|
Equity |
25% |
10.0% |
2.50% |
|
|
100% |
|
7.00% |
The WACC is 7.00%, in between the lower (6.0%) and the higher (10.0%).
[Note for advanced readers: Yes, I'm deliberately ignoring the principal-amortization component; and yes, that slightly mis-states the true net-debt-service-constant results. This is an introductory post, so we are allowed such simplifications for the sake of clarity.]
What happens as the leverage rises? Because debt is cheaper than equity, increasing the percentage of debt should make the WACC decline, and so it does:
Financing Mix 2
|
Source |
Percentage |
Rate |
Net cost |
|
First loan |
85% |
6.0% |
5.10% |
|
Equity |
15% |
10.0% |
1.50% |
|
|
100% |
|
6.60% |
In this example, boosting leverage from 75% to 85% drops the WACC from 7.00% to 6.60%.
We can also get there a slightly more roundabout way, by adding a new layer in between the debt and equity:
Financing Mix 3
|
Source |
Percentage |
Rate |
Net cost |
|
First loan |
75% |
6.0% |
4.50% |
|
Mezzanine debt |
15% |
9.0% |
1.35% |
|
Equity |
10% |
10.0% |
1.00% |
|
|
100% |
|
6.85% |
Debt of this kind is called mezzanine because in the capital stack it comes above (paid after) the first mortgage, but below (paid before) the equity.
In this new example, the mezzanine debt has served two purposes: it has lowered the overall cost of capital, and it’s reduced the amount of hard equity the sponsor had to contribute. An investment banker who delivers Financing Mix 3 (after starting from Financing Mix 1) has done her client a real service.
Three different WAC’s at your service, sir!
Why does WACC matter? Because, in income-producing property such as affordable rental housing, WACC determines value: changes in WACC drive property values up and down.
“I may be just a little number, but I can raise your big asset value.”
Let’s consider a simple example: an apartment that achieves $950 a month in rent and costs $450 in monthly operating expenses, leaving $500 per month of Net Operating Income (NOI). If we use Financing Mix 1 (WACC of 7.00%), today that apartment is worth $85,700 ($6,000 / 7.00%).
As a result, changing the WACC raises or lowers the property’s value even while the property itself is entirely unchanged. For instance, watch what happens as the WACC walks up and down in baby steps of twenty basis points:
“Twenty beeps at a time….”
Yep, each of those twenty-basis-point baby steps means $2,500 of property value. So when our developer visits his banker, she shows him three schedules leading to the following results:
|
Financing mix |
WACC |
Equity required |
Property value |
Change per apartment |
|
1: Simple |
7.00% |
25% |
85,700 |
Baseline |
|
2: Higher first |
6.60% |
15% |
90,900 |
+$5,200 |
|
3: Mezzanine |
6.85% |
10% |
88,200 |
+$2,500 |
In finance, complexity normally adds value. Investment banking — that is, mixing structured finance — has now offered our developer two choices, both of which are better than the baseline case. As between the two of them, however, it’s more complicated: the mezzanine approach (Mix 3) costs a little more than the straight-debt approach, and so it reduces the property’s value, but in exchange it reduces the owner’s equity required.
Which is best?
Depends on what the sponsor’s after, how much equity the sponsor has available, and whether there are more deals on tap.
Got any more deals for me, barkeep?
