Every business owner faces a crucial question: What is the cost of funding a business? Digital Masterjee, Professor Vishal Thakkar, shares key insights to help entrepreneurs manage their capital efficiently.
What is the Weighted Average Cost of Capital (WACC)?
The Weighted Average Cost of Capital (WACC) is an essential technique for reducing the cost of funds. It helps businesses decide the right mix of debt and equity to minimize financial burdens.
Example: How WACC Works
Imagine Mr. Ratan Tata starting an electric car manufacturing business. He has two funding options:
- Bank Loan at 14% interest
- Equity Financing at 16% cost
His capital structure options are:
- 50-50 Split (₹50 Cr Loan + ₹50 Cr Equity) → 15% Cost of Capital
- 40-60 Split (₹40 Cr Loan + ₹60 Cr Equity) → 15.2% Cost of Capital
- 60-40 Split (₹60 Cr Loan + ₹40 Cr Equity) → 14.8% Cost of Capital
The third option is the best because it keeps the cost of funds lower at 14.8%.
How Debt Saves Tax
Tax is another major factor affecting business profits. Many businesses take loans to save tax. Let’s analyze how:
| Parameter | Company A (With Loan) | Company B (Without Loan) |
|---|
| Loan Amount | ₹500 Cr | ₹0 |
| Profit Before Tax | ₹50 Cr | ₹50 Cr |
| Tax Rate | 35% | 35% |
| Tax Paid | ₹17.5 Cr | ₹35 Cr |
| Interest Paid on Loan | ₹50 Cr | ₹0 |
Company A paid less tax because interest on loans reduces taxable income. Company B, without debt, paid full tax.
Formula to Calculate Cost of Funds
Use this formula to determine the cost of capital:
Cost of Funds = (Proportion of Equity × Cost of Equity) + (Proportion of Debt × Cost of Debt)
Golden Rule
As debt increases, the cost of capital decreases.
Massive Action Plan
- Balance Debt and Equity – A good mix ensures financial stability.
- Never Aim for Zero Debt – Some debt keeps capital costs under control.
- Tax Planning – A strong capital structure reduces tax liabilities.
- Build Relationships – Maintain strong ties with bankers and investors.
By managing debt and equity wisely, businesses can reduce costs and maximize profits. Make informed financial decisions to keep your business financially healthy!
