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I learned the other day that the Weighted Average Cost of Capital (WACC) is defined as follows: enter image description here

Source: https://en.wikipedia.org/wiki/Weighted_average_cost_of_capital

Basically, investors give money to the company via either debt or equity financing. Those investors expect a return r_i on their investment. The WACC weights the return by how much money the investors has, giving an overall expected rate of return that the company must meet in order to satisfy investors.

My question is, prior to securing money from investors, suppose founders put their own money into the company or get donations that require no compensation. Does that money count towards the WACC?

Presumably, the founders hope for a return on their own investment in the company, so I wasn't sure why it wouldn't contribute to the rate of return they seek to achieve.

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  • What is the personal finance angle on this question?
    – JohnFx
    Commented Nov 16, 2021 at 18:11
  • @JohnFx analyzing stock market fundamentals is certainly Personal Finance if you’re the nerdy type.
    – RonJohn
    Commented Dec 12, 2022 at 3:25
  • There are no donations in business.
    – RonJohn
    Commented Dec 12, 2022 at 3:27

3 Answers 3

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Equity = shares bought in the company [including the initial investors] + net historical income - dividends paid out. So, the required return on equity is not just based on the initial share purchases, it includes any increases to equity [you suggested 'donations', but more realistic would just be net income].

If I start a business for $100 in share purchases, and it earns $200, and then I borrow $50 of debt, my total capital would be $350, and WACC would be based on ((the rate of interest on debt * $50) + (the rate of return needed on equity * $300)) /350.

WACC is not an exact number per se [especially for private businesses where the true cost of equity can be hard to quantify]. More so, it is a signal of the consideration that must be made that capital contributors [both debt and equity] could pull their money and invest elsewhere, and they should earn something commensurate with the risk they are assuming. Rough numbers can be helpful to build a framework of understanding as to the impacts of changing the company's capital structure [level of debt vs level of equity].

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  • Just to clarify though, WACC does include the initial investments from the founders though, correct? if so, this answers my question and I can accept. Commented Nov 16, 2021 at 6:17
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    @StanShunpike yes, because the investment from the initial founders are (most likely) equity.
    – ssn
    Commented Nov 16, 2021 at 12:24
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    @StanShunpike WACC should consider the cost of debt + the cost of equity. No matter how money ends up in the company, it is one of those two things. Commented Nov 16, 2021 at 13:35
  • How about valuing "sweat equity" as equivalent to the wage each founder could be earning if working elsewhere? Total up those hours at those wage rates to estimate the equity contribution. Commented Nov 16, 2021 at 23:14
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    @OrangeCoast-reinstateMonica Well underpaid labour by owners either results in additional profit or it doesn't. If it results in profit, that profit naturally becomes equity on the balance sheet. If it doesn't result in profit, then the value in that effort isn't definable in a way practical to include on a balance sheet. [That doesn't mean there's no value in it, but undefined 'future value' goes beyond the information that financial statements are intended/able to convey]. Commented Nov 17, 2021 at 1:43
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suppose founders put their own money into the company or get donations that require no compensation

If a founder puts their own money into a company, they would almost always get an ownership stake in return (otherwise there would be no way to get their money back if the company does well). Donations are considered "revenue" and are part of the company's equity.

But, that distinction is irrelevant when talking about WACC. What WACC is used for is to determine the "required" rate of return for a project. Meaning how much would a company have to pay for additional capital for a new project (or possibly, would that capital be better off used to pay down debt/buy back equity). If you assume that the company keeps the capital structure (debt/equity ratio) the same, you would look at the market value of debt and equity (how much return would new debt and equity expect to get) in the same proportion. What the expected rate of return was initially on previous debt or equity is largely irrelevant.

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Yes, this money is counted for WACC. Because founders expect some returns on capital investments. If they don’t expect any return, equity cost would be zero. This WACC is just a parameter to compare with the actual returns from the business to find out the if the business has been able to fulfil the expectations of fund providers or not.

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