Underinvestment Problem

Finance allah shmoop What is a lack model That's whack

Yeah it is people We had to go there once

okay we're done Quack stands for weighted average cost of

capital and whoa yeah that's a mouthful heavy term but

the concept's pretty simple All right Well let's say you

run the famed charcoal smoker producer grills grills grills or

grilles Cubed is matthew people like you said and you

want to buy We've got gas The finest purveyor of

propane grills on the market which will help grills Grilled

grills rule the outdoor barbecue market no matter what their

customers Fuel of choices Well you need to borrow a

ton of money to buy out your competitors A billion

dollars worth of borrow in fact it's so much dough

that you have to borrow it from three different places

Well the money you're borrowing is the capital You need

to buy your target We've got gas That's your target

Okay capital c and wacker at least one Well the

bank demands that the bank comes first in priority Should

things you know go awry and you go the b

word Yeah Bankruptcy We we don't like to say that

too loudly Run banks Okay well the bank will loan

you two hundred million dollars and we'll charge you five

percent interest on that money That five percent is your

cost of capital from that bank lender for funding round

number two while you turned a sweet and beatrix who

in addition to being a killer grill meister in her

own right Well she also happens to be loaded So

anti b agrees to loan you the second traunch of

money and we'll come in second in priority behind the

bank in collecting her dough Should you know the b

word happened She'll own you seven hundred million at seven

percent interest Great So now you only have to raise

your last hundred million box and it has to come

third in the priority stack up of collecting Should things

go you know awry With no other options you hit

up tony mafia ony the shadiest loan shark on either

side of the mason dixon So you pay your respects

you know just the glove with tongue and things get

a little weird But somehow at the end of the

day you walk away from tony's headquarters with a wallet

full of cash as your stomach is full of non

amalfi onis sunday raghu what That last hundred million box

comes with a very high interest price Twelve percent So

when the tony notes ironically that quack is the same

noise that baseball bats make when they hit knees when

will you pay attention And you do the math keenly

aware that the waiting's here are very different looks like

this and that the huge middle traunch of seven hundred

mil it's seven percent has the biggest effect on your

cost of capital because well it's a big fat seventy

percent of the total amount you're borrowing Well the first

two hundred mill is cheap at five percent and it

costs you ten million bucks here to rent that money

The second trunk of seven hundred million is kind of

sort of mad sheepish at seven percent and it costs

forty nine mil a year to rent and that last

traunch of one hundred mil is super expensive for what

you're getting costing you twelve million a year to rent

So you add up the capital rental costs of ten

plus forty nine plus twelve and you get seventy one

million box to rent a billion dollars for this transaction

that seventy one mil to rent a bill and pay

that runs So what is your whack or weighted average

cost of capital Well seventy one million over a billion

or seven point one Percent The black models always percentage

Some companies will use their stock to buy a competitor

er rather than using cash But that's not always the

case and calculating the cost of equity is way more

complex and involves a lot more smoke and or mirrors

So we're just doing debt here people and there you

have it Whack in a nutshell But you know what's

not whack shmoop snu finance themed hip hop album on

sale soon coming soon to a itunes thinking you're you 00:04:04.93 --> [endTime] yeah we'll eat your heart out there hamilton