The company’s fundamental objective is to generate value for its shareholders. In practice this means that the return on investment achieved by the company must be at least equal to the cost of the company’s capital.

An example will help you understand the concept. Imagine that Luiz is an entrepreneur who plans enter the clothing sector. Luiz studies the market, investments, etc. and concludes that the total investment (fixed and working capital) will be R$1 million.

Luiz has funds invested in the savings account that would allow him to invest R$ 500 thousand in the company, to make up the difference, then decides to apply for bank financing of R$ 500 thousand.

Suppose Luiz wants a return of 20% per year for his application of resources (BRL 500,000) in the company, because they think this is a rate compatible with the risk relatively high in the apparel sector. In summary, the three types of income that are in the Luiz’s focus:

  • Savings account: 8% per year
  • Premium for the risk of investment in the company: 12% per year
  • Desired total return on investment in the company: 20% per year = 8% + 12%

Consider that the bank approves the financing of R$ 500 thousand – which Luiz needs to complete the Total investment – with an interest rate of 16% per annum. Thus, the weighted average cost of capital of the company is 18% per year. In summary, we have this cost of capital for the company:

  • Contracted to the bank: 16% per year; referring to R$ 500 thousand.
  • Expected to be earned by Luiz: 20% per year; also for R$ 500 thousand.
  • Average: 18% = ((16% x R$ 500 thousand + 20% x R$ 500 thousand) / (R$ 500 thousand + R$ 500 thousand))

Now imagine that the company was opened in early 2017 and achieved this performance in the year:

  • Net sales revenue: BRL 800 thousand
  • Operational payments and investments: R$600 thousand.
  • Annual cash flow: R$200 thousand = R$800 thousand – R$600 thousand.
  • Profitability obtained by the company: 20% per year = R$ 200 thousand / R$ 1 million.

Thus, everything happens as the company has raised funds of R$ 1 million (with Luiz and the bank) at the weighted average cost of capital of 18% per annum and generated a return of 20% per annum, aggregating 2% return for Luiz in addition to the return he considered adequate.

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