Weighted average cost of capital is the average cost of the costs of various sources of financing. Weighted average cost of capital is also known as composite cost of capital, overall cost of capital or average cost of capital.

Once the specific cost of individual sources of finance is determined, we can compute the weighted average cost of capital by putting weights to the specific costs of capital in proportion of the various sources of funds to the total. The weights may be given either by using the book value of the source or market value of the source.

If there is a difference between market value and book value weights, the weighted average cost of capital would also differ. The market value weighted average cost would be overstated if the market value of the share is higher than the book value and vice-versa. The market value weights are sometimes preferred to the book value weights because the market value represents the true value of the investors.

However, the market value weights suffer from the following limitations:

(i) It is very difficult to determine the market values because of frequent fluctuations,

(ii) With the use of market value weights, equity capital gets greater importance.

For the above limitations, it is better to use book value which is readily available.

Weighted average cost of capital can be computed as follows:

Kw = ∑XW/∑W

where, Kw = Weighted average cost of capital

X = Cost of specific source of finance

W = Weight, proportion of specific source of finance

Illustration 1:

A firm has the following capital structure and after-tax costs for the different sources of funds used:

You are required to compute the weighted average cost of capital.

Solution:

Illustration 2:

Continuing illustration 19, it the firm has 18,000 equity shares of Rs. 100 each outstanding and the current market price is Rs. 300 per share, calculate the market value weighted average cost of capital assuming that the market values and book values of the debt and preference capital are same.

Solution:

Illustration 3:

The following is the capital structure of Saras Ltd. as on 31-12-2007:

The market price of the company’s share is Rs. 110 and it is expected that a dividend of Rs. 10 per share would be declared after 1 year. The dividend growth rate is 6%.

(i) If the company is in the 50% tax bracket, compute the weighted average cost of capital.

(ii) Assuming that in order to finance an expansion plan, the company intends to borrow a fund of Rs. 20 lacs bearing 14% rate of interest, what will be the company’s revised weighted average cost of capital? This financing decision is expected to increase dividend from Rs. 10 to Rs. 12 per share. However, the market price of equity share is expected to decline from Rs. 110 to 105 per share.

Solution:

Illustration 4:

The following is the capital structure of a company:

The current market price of the company’s equity share is Rs. 200. For the last year the company had paid equity dividend at 25 per cent and its dividend is likely to grow 5 per cent every year. The corporate tax rate is 30 per cent and shareholders personal income tax rate is 20 per cent.

You are required to calculate:

(i) Cost of capital for each source of capital.

(ii) Weighted average cost of capital on the basis of book value weights.

(iii) Weighted average cost of capital on the basis of market value weights.

Solution: