Measurement of Overall Cost of Capital

Overall cost of capital means the weighted average of the cost of each component of capital. It repre­sents the combined cost of capital of various sources such as debt, preference, equity and retained earn­ings.

The measurement of overall cost of capital involves the following steps:

Step 1:

Computing specific cost of capital for each source of capital like cost of equity, cost of debt, cost of retained earnings and cost of preference shares.

Step 2:

Assigning proper weights to specific costs; the weight may be the book value or market value.

Step 3:

Multiplying the cost of each source by appropriate weights to derive total weighted cost.

Step 4:

Dividing the total weighted cost by total weight. We know two types of weights can be used for computing the overall cost of capital: Book value and market value.

These are discussed below:

i. Book Value:

Under this method, the book value of different sources of finance is used as weight for computing overall/weighted average cost of capital. Here it has been assumed that new finances are raised in same proportion as the firm currently has in its capital structure. Book value weight is the proportion of book value of various sources of capital in the capital structure.

So for example, the weight for equity will be EB/B, where EB is the book value of equity and B is the total book value of all the sources of capital. Hence overall cost of capital or weighted average cost of capital (WACC) using book value weight may be calculated as:

Where, KO = Overall cost of capital,

ADVERTISEMENTS:

Ke = Cost of equity.

EB = Book value of equity capital.

B = Total book value of all the sources of capital,

Kr = Cost of retained earnings,

RB = Book value of retained earnings,

Kp = Cost of preference shares,

PB = Book value of preference shares,

Kd = Cost of debt, and

DB = Book value of Debt.

i. Market Value:

This method uses the current market price of different sources of capital as weight for computing overall/weighted average cost of capital. It is a more realistic and reasonable method for computing overall cost of capital because the market value of various sources of capital closely approximates the actual amount to be received from issuing such securities and the costs of spe­cific sources of capital are calculated using market values.

Market value weight is the proportion of market value of various sources of capital in the capital structure. So for example, the weight for equity will be EM/M where EM is the market value of equity and M is the total market value of all the sources of capital.

Hence the overall cost of capital or weighted average cost of capital (JV4CC) using market value weight may be calculated as:

WACC = Ko = Ke EM/M + Kr RM/M + KP PM/M + Kd DM/m

Where, Ko = Overall cost of capital,

Ke = Cost of equity,

EM = Market value of equity capital,

M = Total market value of all the sources of capital,

Kr = Cost of retained earnings.

RM = Market value of retained earnings,

KP = Cost of preference shares,

PM = Market value of preference shares,

Kd = Cost of debt, and

DM = Market value of debt.

Example 4.1:

Capital structure of Anuradha Ltd., along with respective specific cost of capital is given below.

You are required to compute the weighted average cost of capital using:

(a) Book value as weight and

(b) Market value as weight.

So, weighted average cost of capital using book value weight is 13.6% and using market value weight is 13.89%.

http://www.yourarticlelibrary.com/financial-management/cost-of-capital/measurement-of-overall-cost-of-capital/43874