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Principles of Finance: Unit 7, The “Best” Capital 7 Views
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Description:
What’s the “best” capital? We think it’s Sacramento, but we might be biased. …Oh, financial capital? We better watch the video for that answer.
Transcript
- 00:00
Principles of finance Ah la shmoop the best capital Okay
- 00:05
so we're about to get into something that is really
- 00:08
whack Yeah the weighted average cost of capital and yeah
- 00:13
that's What wall street is calling wak wak model Think
- 00:16
about the notion of borrowing one hundred million bucks for
Full Transcript
- 00:19
a drone factory A sauce bottle Er or ah you
- 00:22
know a hair extension threat Er thing to a bank
- 00:25
They're all just the capital They rent out tio People
- 00:28
like you running a business to make a profit The
- 00:31
theory goes something like this When you have a funding
- 00:33
event you take the cheapest capital first until its availability
- 00:38
runs out And then you move on to the next
- 00:40
cheapest capital and continue lather rinse repeat until well your
- 00:45
funding is funded That is if debt cost five percent
- 00:48
to rent and you somehow figure out i'ii guest inmate
- 00:51
that the cost of preferred equity was seven point five
- 00:55
percent to rent and the cost of common eh Cody
- 00:58
was a ten percent and you needed one hundred million
- 01:01
dollars Yeah well then you take all the debt you
- 01:03
could't five percent to get that hundred million bucks funded
- 01:06
But a savvy lender might not want to be so
- 01:08
exposed and be all of your hundred million dollars So
- 01:11
maybe they'd say i'll cap you a twenty million bucks
- 01:13
like loan you twenty million dollars at five percent interest
- 01:16
and tell you to find the rest of money elsewhere
- 01:19
makes it more complex doesn't it Well then you look
- 01:21
to the preferred stock offerings and you think about del
- 01:24
maybe raising thirty million dollars there as a preferred stock
- 01:28
offering which just sits above the common but below the
- 01:31
dead in case things really go a ride and to
- 01:33
top things off Well then you'll finish with that last
- 01:36
fifty million dollars of that you need for the hundred
- 01:38
million dollars whatever factory so you're blended capital cost are
- 01:42
weighted average cost of capital here or whack would be
- 01:46
at twenty five and then thirty att seven point five
- 01:50
and fifty ten and those are hundreds of million dollars
- 01:53
You see their interest rates you'll pay is one two
- 01:55
and a half five it's really not a cash costs
- 01:57
in case the common because sold a part of yourself
- 02:00
so it's a different in a weird way it's way
- 02:01
more expensive than the other two alternates So the total
- 02:04
cost of this hundred million dollars raise is eight point
- 02:07
five million dollars a year for a weighted average cost
- 02:11
of eight point five percent Well this root system is
- 02:13
fine in a laboratory vacuum with financial rats borrowing the
- 02:16
money But in the real world a lot of other
- 02:18
issues affect your decision making not the least of which
- 02:21
revolves around the volatile till it e of the business
- 02:23
you're in Why volatilities Well if you have fifty million
- 02:26
dollars in cash profits in a given year and three
- 02:29
hundred million dollars in eight percent debt well the twenty
- 02:32
four million you have in interest is less than half
- 02:35
your profits So payment of it is a snap meaning
- 02:37
it's easy to make that payment and maur If you
- 02:40
want to pay down the principal you have a cushion
- 02:42
at least twenty six million box in this example ignoring
- 02:45
the fact that all of the twenty four million in
- 02:47
interest cost is also tax deductible So it'll feel like
- 02:51
even less than twenty for when you know you go
- 02:53
to write those checks But if you have a highly
- 02:56
cyclical business like let's say you sell green washing machines
- 03:00
Well in good times you sell a lot of them
- 03:02
in bad times Now you just sit there watching the
- 03:05
loads go round and round So when a goodyear yeah
- 03:07
you earned fifty million dollars but in a bad year
- 03:10
you lose ten million Do the bondholders take a break
- 03:13
from collecting the money you owe them in bad years
- 03:16
Oh sure they just pat you on the back with
- 03:18
a wink and say hey but i got this Don't
- 03:20
worry about the interest this year No it's just the
- 03:23
opposite In fact they want to get paid and they
- 03:26
do get paid or they take over ownership of your
- 03:29
company or whatever you pledge by the money they loaned
- 03:31
you If you live in a highly volatile business climate
- 03:34
or arena While you can't afford much in the way
- 03:37
of debt financing that is if you must raise capital
- 03:41
well you often have to sell equity or ownership in
- 03:44
yourself which is kind of a perp actual cost and
- 03:47
it usually costs a lot more than dead if you
- 03:49
really do careful math on it because you can't afford
- 03:52
the downside of that volatility so capital becomes essentially way
- 03:56
more expensive in volatile businesses for cyclical business is very
- 04:00
small Debt is often find but companies do go bankrupt
- 04:03
in bad times all the time in cyclicals who over
- 04:06
borrowed like you know the auto into hello g m
- 04:09
we're looking at you All right Well on the other
- 04:10
hand if you do live in a low volatility world
- 04:13
like the cable industry or the electric utilities industry or
- 04:16
the fast food industry or legal drugs then you can
- 04:20
afford lots of debt because things would have to get
- 04:23
unbelievably bad before people turn off their reality tv Stop
- 04:27
using the heat and you know quit eating tacos Those
- 04:31
industries get the benefit of quote chief for capital unquote
- 04:34
in the form of being able to use debt financing
- 04:37
to grow or roll out new product or buy back
- 04:40
stock or pay a dividend whatever they want So yeah
- 04:42
when your grocery chain is looking to unleash its new
- 04:45
tastes like chicken gelato on the unsuspecting public cheap debt
- 04:49
capital it is probably the way to go and then
- 04:52
just keep your fingers crossed that everyone will have a
- 04:54
taste for poultry flavored dairy products Yeah what do you 00:04:57.35 --> [endTime] think That is pretty foul
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