    # Weighted Average Cost Of Capital (WACC) The term Cost of Capital refers to the over-all composite cost of capital. It is defined as the Weighted Average Cost of Capital (WACC). The percentage or proportion of various sources of finance used by a company is different. For example, not all companies would have 33.33% of debt, 33.33% of preference capital and 33.33% of equity. This is not practical and hence we use the weighted average and not the simple average. Thus, the overall cost of capital should take into account the respective proportions of various sources of funds and hence the weighted average comes into question.

The computation of the over-all cost of capital involves the following steps:
• Calculate the cost of specific source of funds such as the cost of debt, cost of preference capital, cost of equity and cost of retained earnings.
• Multiplying the cost of each of the sources by its weight which is obtained by calculating its' proportion to the total capital.
• Add these weighted costs from all the sources of funds to arrive at weighted average cost of capital.

Given the cost of specific source of finance and the scheme of weighing, the WACC can be calculated as follows:

WACC = We Ke + Wp Kp + Wd kd (1 - t)

Where:

We     = Proportion of Equity
Wp     = Proportion of Preference
Wd     = Proportion Debt
Ke      = Cost of equity capital
Kp      = Cost of preference capital
Kd      = Cost of debt
t         = Tax rate

But where Kd after tax is taken, (1 - t) can be eliminated from the formula.

WACC can be calculated using Book Value weights or Market value weights. Market value weights are more practical because it reflects the expectations of the investors and market value closely reflects how a company has to raise new capital.

Book value weights:

Here, the book value of different sources of capitals already in use is considered for the purpose of obtaining the proportions in which they are used. These proportions are used as weights for calculating the weighted average cost of capital.

Example using Book value weights: The respective book values and cost of specific capitals are given. Let us determine the WACC.

Debt: \$15,000, 2.79% Preference: \$10,000, 7.84% Equity \$20,000, 8.67% and Retained earnings \$5,000, 8.31%.

 Source Book Value Percentage to Total % Cost of specific Capital % Weighted Cost Debt \$5,000 30 2.79 0.837 Preference \$10,000 20 7.84 1.568 Equity \$20,000 40 8.67 3.468 Retained Earnings \$5,000 10 8.31 0.831 \$50,000 100 6.704%

WACC = 6.70%

Market value weights:

Instead of using book value, the market values of various sources of capital are used in assigning weights. This is more practical for raising new capital.

Example using Market Value weights: Let us calculate the WACC of:

Debt: \$18,000, 3.70% Preference: \$9,000, 7.00% Equity \$40,000, 9.50% and Retained earnings \$5,000, 8.31%.

 Source Book Value Percentage to Total % Cost of specific Capital % Weighted Cost Debt \$18,000 25.00 3.70 0.925 Preference \$9,000 12.50 7 0.875 Equity \$40,000 55.56 9.50 5.278 Retained Earnings \$5,000 6.94 8.31 0.577 \$72,000 100.00 7.655

WACC = 7.66%

(Instead of dividing it by 100 and arriving at 0.925 in the first case, we can also have it as a percentage as 92.50% everywhere and then at last divide it by 100. Both will fetch the same answer.)

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Weighted Marginal Cost of Capital:

The weighted average cost of capital generally tends to rise as the firm seeks more and more capital. This may happen because the supply schedule of capital is typically upward sloping - as suppliers provide more capital, the rate of return required by them tends to increase. A schedule or a graph showing the relationship between additional financing and the weighted average cost of capital is called the weighted marginal cost of capital schedule.

Determination of Weighted Marginal Cost of capital schedule

The determination of WMCC involves the following steps:
• Estimation of cost of each source of financing for various levels of its use through an analysis of current market conditions and an assessment of the investors' expectations.
• Identification of the levels of total new financing at which the cost of the new components would change, given the capital structure policy of the firm. These levels are called as breaking points.
• Calculation of WACC for various ranges of total financing between the breaking points.
• Preparation of WMCC schedule which reflects the WACC for each level of total new financing.

Factors affecting Weighted Average Cost of Capital:
• Factors outside a firm�s control:
• Interest rate levels
• Tax rates
• Factors within a firm�s control:
• Investment policy
• Capital structure policy
• Dividend policy       • 