Page 118 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 5: Cost of Capital

Illustration 26: HLL has provided the following information and requested you to calculate (a) Notes
WACC using book-value weights and (b) weighted marginal cost of capital (assuming that
specified cost do not change).

Source of Finance Amount ( ) Weights (%) After tax cost (%)
Equity capital 14,00,000 0.452 9
Preference capital 8,00,000 0.258 12
Debentures 9,00,000 0.290 16

HLL wishes to raise an additional capital of 12,00,000 for the expansion of the project. The
details are as follows:
Equity capital 3,00,000
Preference capital 3,00,000
Debentures 6,00,000
Solution:
Computation of WACC

Source of Finance Weights After tax Cost (%) Weighted Cost
Equity capital 0.452 0.09 0.041
Preference capital 0.258 0.12 0.031
Debentures 0.290 0.16 0.046
0.118

WACC = 0.118 × 100 = 11.8 per cent
Computation of Weighted Marginal Cost of Capital (WACC)

Source of Finance Marginal Weights After tax Cost (%) Weighted marginal cost
Equity capital 0.50 0.09 0.045
Preference capital 0.25 0.12 0.030
Debentures 0.25 0.16 0.040
0.115

WACC = 0.115 × 100 = 11.5 per cent

5.5.3 Factors Affecting WACC

Weighted average cost of capital is affected by a number of factors. They are divided into two
categories such as:

1. Controllable Factors: Controllable factors are those factors that affect WACC, but the firm
can control them. They are:
(a) Capital Structure Policy: As we have assured, a firm has a given target capital structure
where it assigns weights based on that target capital structure to calculate WACC.
However, a firm can change its capital structure or proportions of components of
capital that affect its WACC. For example, when a firm decides to use more debt and
less equity, which will lead to reduction of WACC. At the same time increasing
proportion of debt in capital structure increases the risk of both debt and equity
holder, because it increases fixed financial commitment.

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