1. Weighted Average Cost of Capital

2. The Weighted Average Cost of Capital
The following steps are involved for calculating the firm’s WACC:
Calculate the cost of specific sources of funds
Multiply the cost of each source by its proportion in the capital structure.
Add the weighted component costs to get the WACC.
WACC is in fact the weighted marginal cost of capital (WMCC); that is, the weighted average cost of new capital given the firm’s target capital structure.

3. Book Value Versus Market Value Weights
Managers prefer the book value weights for calculating WACC:
Firms in practice set their target capital structure in terms of book values.
The book value information can be easily derived from the published sources.
The book value debt—equity ratios are analysed by investors to evaluate the risk of the firms in practice.

4. Book Value Versus Market Value Weights
The use of the book-value weights can be seriously questioned on theoretical grounds:
First, the component costs are opportunity rates and are determined in the capital markets. The weights should also be market-determined.
Second, the book-value weights are based on arbitrary accounting policies that are used to calculate retained earnings and value of assets. Thus, they do not reflect economic values.

5. Book Value Versus Market Value Weights
Market-value weights are theoretically superior to book-value weights:
They reflect economic values and are not influenced by accounting policies.
They are also consistent with the market-determined component costs.
The difficulty in using market-value weights:
The market prices of securities fluctuate widely and frequently.
A market value based target capital structure means that the amounts of debt and equity are continuously adjusted as the value of the firm changes.

6. Overall cost of capital
Book Value weights:
A firm’s after tax cost of capital of the specific sources is as follows: Calculate Ko
Capital stucture
cost
amount
Debt 8%
3,00,000
Preference
14%
2,00,000
Equity
17%
5,00,000

7. Ko (Book Value) Fund Amount Propotion cost Weighted cost Debt 3,00,000.3
8%= 24,000
0.024(.08*.3)
Preference
2,00,000 .2
14%= 28,000
0.028
Equity
5,00,000 .5
17%= 85,000
0.085
1,37,000
1.37
Ko = .137*100 =13.7%
1,37,000
Ko = *100
10,00,000
13.7%

8. Ko- Market Value Source Specific Cost Market Value Book Value Debt 8%
2,70,000
3,00,000
Preference
14%
2,30,000
2,00,000
Equity & Retained earnings
17%
7,50,000
5,00,000

9. Find out the market value for retained earnings
7,50,000-5,00,000
= * 100
12,50,000
= 20%
Retained Earnings = 7,50,000*20/100
= 1,50,000

10. Computation of Ko (Market Value Weights)
Sources
Market Value
Cost%
Total cost
Debt
2,70,000 8
21,600
Preference
2,30,000 14
32,200
Equity
6,00,000 17
102000
Retained earnings
1,50,000
25,500
12,50,000
1,81,300
1,81,300
Ko = *100
12,50,000
= 14.5%

11. Overall cost of capital
Book Value weights:
A firm’s after tax cost of capital of the specific sources is as follows: Calculate Ko
Capital stucture
cost
amount
Debt 6%
4,00,000
Preference
10%
2,00,000
Equity
13%

12. Flotation Costs, Cost of Capital and Investment Analysis
A new issue of debt or shares will invariably involve flotation costs in the form of legal fees, administrative expenses, brokerage or underwriting commission.
One approach is to adjust the flotation costs in the calculation of the cost of capital. This is not a correct procedure. Flotation costs are not annual costs; they are one-time costs incurred when the investment project is undertaken and financed. If the cost of capital is adjusted for the flotation costs and used as the discount rate, the effect of the flotation costs will be compounded over the life of the project.
The correct procedure is to adjust the investment project’s cash flows for the flotation costs and use the weighted average cost of capital, unadjusted for the flotation costs, as the discount rate.

13. Divisional and Project Cost of Capital
A most commonly suggested method for calculating the required rate of return for a division (or project) is the pure-play technique.
The basic idea is to use the beta of the comparable firms, called pure-play firms, in the same industry or line of business as a proxy for the beta of the division or the project.

14. Divisional and Project Cost of Capital
The pure-play approach for calculating the divisional cost of capital involves the following steps:
Identify comparable firms.
Estimate equity betas for comparable firms.
Estimate asset betas for comparable firms.
Calculate the division’s beta.
Calculate the division’s all-equity cost of capital.
Calculate the division’s equity cost of capital.
Calculate the division’s cost of capital.