A firm uses various sources of finance to finance its projects. Each source of finance will be having a specific cost. So in order to determine the overall cost of capital of the firm, the weighted average cost of individual sources of finance should be determined with the weights being the proportion of each type of capital used.
The Weighted Average Cost of Capital (WACC) is defined as the weighted average of the cost of various sources of finance, weights being the book value or market values of each source of finance. If ko represents the weighted average cost of capital or overall cost of capital then,
ko = wdkd + wpkp + wtkt + weke + wrkr
- ko = weighted average cost of capital
- kd = cost of debt
- kp = cost of preferred stock
- kt = cost of term loan
- ke = cost of equity
- kr = cost of retained earnings.
- wd = Proportion of total capital supplied by debt
- wp = Proportion of total capital supplied by preferred stock
- wt = Proportion of total capital supplied by term loan
- we = Proportion of total capital supplied by external equity
- wd = Proportion of total capital supplied by retained earnings
If debt and equity are the only sources of finance used by the firm, the Weighted Average Cost of Capital can be calculated as follows:
WACC = Cost of equity x Proportion of equity in the financing mix + Cost of debt x Proportion of debt in the financing mix
ko = wdkd + weke
ko = ke [E/(D+E)] + kd [D/(D+E)]
- D = proportion of debt in the financing mix
- E = proportion of equity in the financing mix
The weights used in determining the weighted average cost of capital of a firm are historical weights. Historical weights are based on a firm’s existing capital structure. The use of these weights is based on the assumption that the firm’s existing capital structure is optimal and therefore should be maintained in the future. Two types of historical weights can be used – book value weights and market value weights.
- Book Value Weights: The use of book value weights in calculating the firm’s weighted cost of capital assumes that new financing’s will be raised using the same method the firm used for its present capital structure. The weights are determined by dividing the book value of each capital component by the sum of the book values of all the long-term capital sources.
- Market Value Weights: Market value weights are determined by dividing the market value of each source by the sum of the market values of all sources. The use of market value weights for computing a firm’s weighted average cost of capital is more scientific than the use of book value weights because the market values of the securities closely approximate the amount to be received from their sale.
Importance of Weighted Average Cost of Capital
- In capital structure planning a company strives to achieve the optimal capital structure in order to maximize the value of the firm. The optimal capital structure occurs at a point where the overall cost of capital is minimum.
- Since overall cost of capital is the minimum rate of return required by the investors, this rate is used as the discount rate or the cut-off rate for evaluating the capital budgeting proposals.