Weighted Average Cost Of Capital(WACC)
Generally, projects are evaluated on the basis of overall cost of capital, not on the basis of specific cot of capital. The product of component of cost of capital and weight respective source of capital is known as weighted average cost of capital. In other words, weighted average cost of capital is the minimum required rate of return to be earned on investment. Therefore, it is computed on the basis of the proportion of the funds from which the fund has been raised and their respective proportion.
For example, a firm needs $ 5,00,000 for investing in a new project. The firm can collect $ 3,00,000 from shares on which it must pay 12% dividend and $ 2,00,000 from debentures on which it must pay 7% interest. If the fund is raised and invested in the project, the firm must earn at least $ 50,000 which becomes sufficient to pay $ 36,000 dividend(12% of 3,00,000) and $ 14,000 interest (7% of 2,00,000) . The required earning ($ 50,000) is 10% of the total fund raised. This 10% rate of return is called weighted average cost of capital.
Calculation Process Of Weighted Average Cost Of Capital (WACC)
Step I: calculation of component or specific cost of capital:
* After tax cost of debt (kdt)
* Cost of preference share (kp)
* Cost of equity share (ke)
* Cost of retained earnings( kr)
Step II: Calculation of proportion or weight of source of capital:
* Proportion or weight of debt (Wd) = Amount of debt/Total Capital
* Weight of preference share (Wp) = Amount of preference share/Total capital
* Weight of equity share (We)= Amount of equity share/Total capital
* Weight of retained earnings (Wr)= Amount of retained earnings/ Total capital
Step III: Calculation of Weighted average cost of capital (WACC):
WACC = Wd x kdt+ Wp x kp+ We x ke + Wr x kr
