Weighted Average Cost Of Capital

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Once the specific cost of capital of each of the long term sources i.e., the debt , the preferences share capital, the equity share capital and the retained earning have been ascertained, then the next step is to calculate the overall cost of capital of the firm. This overall cost of capital of the firm is of most importance as this rate is to be used as the discount rate or the cut-off rate in evaluating the capital budgeting proposals. The overall cost of capital may be defined as the rate of return that must be earned by the firm in order to satisfy the requirement of the different investors. The overall cost of capital is thus , the minimum required rate of return on the assets of the firm. This overall cost of capital should take care of the relative proportion of different sources in the capital structure of the firm. Therefore, this overall cost of capital should be calculated  as the weighted average rather than simple average of different specific cost of capital. The weighted average cost of capital( WACC) is defined as the weighted average of the cost of  different sources and may be described as follows:

                WACC  =   k e . wl  +  k d. w2  +  k p.w3

Where  ,WACC =  Weighted average cost of capital
                    k e  = Cost of equity capital
                      k d = After tax cost of debt
                     k p =  Cost of preference share
                     wl  =  Proportion of equity capital in capital structure
                    w2  =  Proportion of debt in capital structure
                    w3 =  Proportion of preference capital in capital structure

As most of the firms use more than one source of capital fund in financing the capital budgeting proposals and because over time, the mix of these sources may change, it is necessary to examine the cost of the firm’s capital structure as a whole. The firm must have a cost of capital that is weighted to reflect the difference in various sources used. It encompasses the cost of compensating the debt investors, preference shareholders and the equity shareholders. So, in order to calculate the WACC, there must be a system of assigning weights to different specific cost of capital.    

The WACC is found by weighing the specific cost of capital for each type of financing by its proportion in the overall capital structure. The weights which ay be assigned and used to find out the WACC may be as follows:

a)    Historical or Existing Weights
b)    Marginal Weights
c)    Target Weights

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