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Composite cost of capital

After ascertaining the cost of each source of the capital constituting the capital structure, the next step is to compute the composite cost of capital which is defined as the weighted average of the cost of each specific type of capital. The reason behind considering weighted average and not the simple average is to give consideration to the proportion of various sources of funds in the capital structure of the company. Thus, the process of computing the composite cost of capital is carried on by following the steps stated below:

1.    Assign weights to various sources of funds. It may be stated here that  weights mey be in the form of book value of funds or market value of funds.
2.    Multiply the cost of each source of funds by the weights assigned.
3.    Calculate the composite cost by dividing total weighted cost by the total weights.

The above process can be explained with the help of following illustration:

The capital structure of a company and the cost of specific sources of funds is as below:

Sources of funds Book value (weights) $ 1 Specific cost 2 Weighted cost $ 3 (1 × 2)
Debentures 1,50,000
5% 7,500
Preference shares 50,000 9% 4,500
Equity shares 2,00,000 15% 30,000
Retained earnings 1,00,000 8% 8,000
Total 5,00,000 

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