 ## 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 –

1. First of all calculate the cost of specific sources of funds.
2. Multiply the cost of each source by its proportion in the capital structure.
3. Add the weighted components costs to obtain weighted average cost of capital.

While making financial decision, after tax costs should be the basis of calculating cost of capital. If we assume that firm has only debt and equity in the capital structure, then WACC (k0) will be –

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 Share Capital 4,50,000 45 Preference Share Capital 1,50,000 15 Reserve and Surplus 1,00,000 10 Debt 3,00,000 30 1,000,000 100

The after tax component costs of the various sources of finance for ABC enterprise are as follows –

 Sources Cost (%) Equity 18 Preference Share Capital 18 Reserve and Surplus 11 Debt 8.0

Find out WACC of the company?

 Source Amount (1) (Rupees) Proportion (%) (2) After tax cost (%) (3) Weighted Cost (%)(4) Equity Capital 4,50,000 45 18 8.1 Reserve and Surplus 1,50,000 15 18 2.7 Preference capital 1,00,000 10 11 1.1 Debt 3,00,000 30 8 2.4 WACC 14.3