Page 115 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

Notes 5.5.1 Steps Involved in Computation of WACC

1. Determination of the type of funds to be raised and their individual share in the total
capitalisation of the firm.
2. Computation of cost of specific source of funds.

3. Assignment of weight to specific costs.
4. Multiply the cost of each source by the appropriate assigned weights.
5. Dividing the total weighted cost by the total weights to get overall cost of capital.

Once the company decides the funds that will be raised from different sources, then the
computation of specific cost of each component or source is completed after which, the third step
in computation of cost of capital is, assignment of weights to specific costs, or specific sources of
funds. How to assign weights? Is there any base to assign weights? How many types of weights
are there?
Assignment of Weights: The weights to specific funds may be assigned, based on the following:
1. Book Values: Book value weights are based on the values found on the balance sheet. The
weight applicable to a given source of fund is simply the book value of the source of fund
divided by the book value of the total funds.
The merits of book values weights are:

(a) Calculation of weights is simple.
(b) Book values provide a usable base, when firm is not listed or security is not actively
traded.

(c) Book values are really available from the published records of the firm.
(d) Analysis of capital structure in terms of debt – equity ratio is based on book value.
Disadvantage of book value weights: Book value proportions are not consistent with the
concept of cost of capital because the latter is defined as the minimum rate of return to
maintain the market value of the firm.

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Caution There is no relation between book values and present economic values of the
various sources of capital.
2. Capital Structure Weights: Under this method, weights are assigned to the components of
capital structure based on the targeted capital structure. Depending up on the target,
capital structures have some difficulties. They are:

(a) A company may not have a well defined target capital structure.
(b) It may be difficult to precisely estimate the components of capital costs, if the target
capital is different from present capital structure.

3. Market Value Weights: Under this method, assigned weights to a particular component of
capital structure is equal to the market value of the component of capital divided by the
market value of all components of capital and capital employed by the firm.
Advantages of Market Value Weights:
(a) Market values of securities are approximately close to the actual amount to be
received from their sale.

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