How do you explain WACC conceptually to a 5 years old? I am struggling to conceptualize this question
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How much it might cost (on avg) to justify xyz project, like building a lemonade stand or merging with another kid’s mobile lemonade wagon to scale throughout the neighborhood.
I think.
I would say something like: there is a project that can only be completed by two groups contributing money, expecting to receive more back. Group one temporarily gives money to the project, earning cash every couple months until they get the money back. Another group lends money with no specific repayment time. But the amount they get back could be more or less depending on the success of the company. Group 2 has a bigger chance of losing money than group 1, so group 1 doesn't have the potential to make as much money.
Something like that. I wouldnt get too much into dividends or types of debt instruments.
Your cost to borrow money to finance a project that hopefully generates a higher return.
I think it’s helpful to think from two perspectives.
1) A Business/management team
The WACC of the business to a management team is its hurdle rate. They should not invest in projects that won’t generate a return higher than their WACC/hurdle rate.
2) An Investor
The WACC of the business to an investor Is the expected return on investing in the business, considering the risk and nature of the investment. It is the rate of return I expect from my investment.
Summary
Investors’ invest money based on the expected returns. As a result, the investors set the hurdle rate for a business. If the business doesn’t allocate capital in a way to generate returns in excess of their hurdle rate, investors will be disappointed => they will withdraw their capital => the business’ hurdle rate will become even higher to entice new investors
TLDR; investors set the hurdle rate/WACC of a business and the management team has to manage accordingly.
Well usually I don’t go around explaining WACC to 5 year olds
I never really got the debt/equity split for WACC, like what the point of having a discount rate on an unlevered basis was. Debt investors will use their required rate of return, equity investors will use theirs. I guess DCF output is just high-level idea of company's worth and the whole sanity-check piece?
I like the point about company's internal hurdle rate, I think that's fair.
Why high level?
As long as your capital structure stays the same, calculating the unlevered free cash flow, i.e., the cash available to both shareholders and debt holders, and discounting it using the average cost of capital is exactly the same as calculating the levered free cash flow and discounting it using the cost of equity. It's not like one is more precise than the other.
That doesn't answer the question in the slightest, just reads like a textbook
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