Question based on DIMS MBA Assignment Solution and other course
Answer:
A company has to employ owner’s fund as well as creditors’ funds to finance its projects so as to make the capital structure of the company balanced and to increase the return to the shareholders. Weighted average cost of capital is the average cost of various sources of financing. According to CIMAthe weightedaverage cost of capital “as the average cost of the company’s finance (equity, debentures, bank loans) weighted according to the proportion each element bears to the total pool of the capital, weighting is usually based on market valuations current yields and costs after tax.”
Weighted average cost of capital is also known as composite cost of capital, overall cost of capital or average cost of capital. The composite cost ol capital is the weighted average of the cost of various sources of funds, weights being the proportion of each source of funds in the capital structure.
The following steps are used to calculate the weighted average cost of capital :
- Calculate the cost of the specific sources of funds (i.e., cost of lit, cost of equity share capital, cost ofpreference share ital, cost of retained earnings etc.). These should be calculated after tax.
- Multiply the cost of each source by its proportion in the capital structure.
- Apply the following formula :
Assignment of Weights: The assignment of weight to specific sources of funds is a difficult task. Several approaches are followed in this regard but two of them are commonly used which are
- Book value weights: Book value weights mean the weights according to the values shown in respect of the different sources of finance in the balance sheet (or in the books of accounts).
- Market value weights: Market value weights mean the weights of different components of capital, according to the value prevailing in the market. The cost of capital of the market value is usually higher than it would be if the book value is used. The market value weights are more logical to be adopted due to the following reasons :
- It represents the true value of funds invested by investors.
- Historic book value have no relevance in calculation of real cost of capital.
- It represents near to the opportunity cost of capital.
However, the market value weights suffer from the following limitations :
- It is difficult to determine the market values because of frequent fluctuations.
- With the use of market value weights, equity capital gets greater importance.
