COST OF CAPITAL

Compiled by: Lalit Arora Assistant Professor School of Management Lovely Professional University

LEARNING OBJECTIVES

Computation of the weighted average cost of capital.

To examine the problems associated with computation of WACC.

To understand the limitations of applicability of the WACC.

W EIGHTED

AVERAGE COST OF CAPITAL

( WACC )

The overall cost of capital is also called WACC.

It is not the simple average but a weighted average. A simple average is not used as the firms hardly use equal proportions of sources of capital.

S TEPS

IN CALCULATING WACC

Calculate the cost of specific sources of funds.

Multiply the cost of each source by its proportion in the capital structure. Add the weighted component cost to get the WACC.

M ARKET

VALUE VS BOOK VALUE WEIGHTS

It is better to use market value weights to calculate WACC.

WACC calculated using the book value weights, will be understated if the market value of the share is higher than the book value and vice versa.

M ARKET

VALUE VS BOOK VALUE WEIGHTS

The following is the book value capital structure of a firm as on 31st March, 2010:
Amount (Rs.) 4,50,000 2,50,000 3,00,000 10,00,000 Cost (%) 18 11 8

Source of finance Share capital* Preference capital Debt Total

* 45,000 equity shares issued @ Rs. 10 each

The WACC = 13.25%.

M ARKET

VALUE VS BOOK VALUE WEIGHTS

Suppose the market value of a share becomes Rs. 20 per share, the capital structure will be altered as:
Amount (Rs.) 9,00,000 2,50,000 3,00,000 14,50,000 Cost (%) 18 11 8

Source of finance Share capital Preference capital Debt Total

The WACC = 14.68%.

L IMITATIONS

OF USING WACC AS A DISCOUNT RATE TO EVALUATE PROJECTS

The computation of cost of capital of specific sources involves beta () values.

The firm is a combination of different projects with different levels of risk involved.

A single discount rate will be too high (low) for different projects.
If the discount rate is too low, the firm may run a risk of selecting a negative NPV project.

A LTERNATIVES

TO USING WACC FOR

EVALUATING PROJECTS

Looking for a pure play comparable (another firm in the similar project). Categorization of projects and using a separate discount rate for each project. Projects can generally be categorized as:
Efficiency projects implementation of new technology to reduce manufacturing cost. Product extension projects variations in the product to meet customers expectations. Market extension projects selling existing products in the new market New product projects entirely new products are being considered.

T HANK

YOU