Page 114 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes Self Assessment

Fill in the blanks:
10. Cost of debenture is equal to the……………., when debenture is issued at par and without
considering tax.
11. Cost of preference share is the ……………that equates the present value of cash inflows
with the present value of cash outflows.

12. Retention of earnings involves an …………….cost.

6.5 Weighted Average Cost of Capital (WACC)
A company has to employ a combination of creditors and fund owners. The composite cost of
capital lies between the least and most expensive funds. This approach enables the maximisation
of profits and the wealth of the equity shareholders by investing the funds in projects earning in
excess of the overall cost o capital.
The composite cost of capital implies an average of the costs of each of the source of funds
employed by the firm property, weighted by the proportion they hold in the firm’s capital
structure.

6.5.1 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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