Page 115 - DMGT405_FINANCIAL%20MANAGEMENT

Unit 6: Cost of Capital

Notes
!
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.
(b) Costs of the specific resources of funds that constitute the capital structure of the
firm, are calculated by keeping in mind the prevailing market prices.
Disadvantages of Market Value Weights
(a) Market values may not be available when a firm is not listed or when the securities
of the firm are very thinly traded.
(b) Market value may be distorted when securities prices are influenced by manipulation
loading.

(c) Equity capital gets greater importance.

Did u know? Most of the financial analysts prefer to use market value weights because it is
theoretically consistent and sound.
Illustration 22:
A firm has the following capital structure as the latest statement shows:

Source of Funds After Tax Cost (%)

Debt 30,00,000 4
Preference shares 10,00,000 8.5
Equity share 20,00,000 11.5
Retained earnings 40,00,000 10

Total 100,00,000
Based on the book values compute the cost of capital.
Solution:

Source of Finance Weights Specific Cost (%) Weighted Cost
Debt 0.30 0.04 0.012
Preference shares 0.10 0.08 Contd...
0.008
Equity share 0.20 0.11 0.022
Retained earnings 0.40 0.10 0.040
LOVELY PROFESSIONAL UNIVERSITY 109
1.00 0.082