What is Weighted Average Cost of Capital (WACC)?
WACC is the overall cost of capital in which cost of each source is multiplied by its proportion in the capital structure and then weighted components are added. The proportion of cost of capital must be based upon the target capital structure. Weighted Average cost of capital is the overall cost of capital. The most important thing to note is that, it is the weighted average capital which is relevant in calculating cost of capital. The simple average cost is not appropriate to use because firms rarely use various source of funds equally in the capital structure.
Calculation of WACC requires the following steps –
- First of all calculate the cost of specific sources of funds.
- Multiply the cost of each source by its proportion in the capital structure.
- Add the weighted components costs to obtain weighted average cost of capital.
k0 = kd (1-T)wd+kewe
k0 = kd(1-T) (D/D+E) + ke (E/D+E)
where kd(1-T) = after-tax costs of debt
ke = after tax cost of equity
So the formula for weighted average cost of capital = k1w1+k2w2+k3w3+…….
Here, k1, k2 and so on are component costs and w1,w2 and so on are the various types of capital employed by the company.
Example of Weighted Average Cost of Capital
ABC ltd has following book value capital structure on 31 March, 2016:
|Sources of Finance||Amount||Proportion|
|Preference Share Capital||1,50,000||15|
|Reserve and Surplus||1,00,000||10|
The after tax component costs of the various sources of finance for ABC enterprise are as follows –
|Preference Share Capital||18|
|Reserve and Surplus||11|
Find out WACC of the company?
|Source||Amount (1) (Rupees)||Proportion (%) (2)||After tax cost (%) (3)||Weighted Cost (%)(4)|
|Reserve and Surplus||1,50,000||15||18||2.7|