Computation of overall cost of capital based on Historical and Market weights (WACC).

1. Introduction

The overall cost of capital (WACC) is a composite or average cost, derived by combining the costs of individual sources of financing, weighted by their proportions in the company's capital structure. It is used as a hurdle rate for investment and other financial decisions. It’s important to understand that the WACC is not a simple average. Rather, it is a weighted average concept, because firms rarely use various sources of funds equally in the capital structure.

2. Steps to Calculate WACC

To calculate a firm's WACC, follow these steps:

1. Calculate Specific Costs: Determine the cost of each individual source of funds (debt, preference shares, equity, and retained earnings) on an after-tax basis.
2. Multiply by Proportions: Multiply the cost of each source by its proportion in the firm's capital structure (the weights).
3. Sum Weighted Costs: Add the weighted component costs to obtain the WACC.

3. Importance of After-Tax Basis

• For financial decision-making, the cost of capital should be calculated on an after-tax basis, making the component costs the after-tax costs.

4. Weighting Approaches

The crucial part of the WACC calculation is the decision regarding the appropriate weights. The weights represent the proportions of different sources of funds and can be based on:

1. Historical Weights
2. Market Value Weights

4.1. Historical Weights

• Concept: These weights use the relative proportions of the various sources of funds in the existing capital structure as a basis for assigning weights. The historical weights are based on the company's past capital structure

• Assumption: The historical weights method assumes the existing capital structure is optimal and should be maintained in the future.

• Proportion: The firm should raise additional funds in the same proportion as they are in the existing capital structure, which implies that the company is raising incremental funds in the same proportion as it has done in the past.

• Example: If the current capital structure is 30% debt, 20% preference shares, 40% equity, and 10% retained earnings, and the company requires additional funds, it should raise new funds in the same proportions.

4.1.1. Problems With Historical Weights

• Assumption Validity: The assumption that the firm should raise additional funds in the same proportion as the existing capital structure is questionable.
• Practical Constraints: Firms may not always have control over the availability of funds from each source, including retained earnings and external capital.
• Capital Market Factors: Raising funds is dependent on market conditions over which the company has no control.
• Choice between Book Value and Market Value: A choice has to be made between using book value or market value when calculating historical weights.

4.1.2. Advantages of Historical Weights

• Long term view: By using historical weights, a long term view of the capital structure is used.
• Optimal Selection: It is more consistent with the firm's goal of maximizing wealth in the long-run. For this reason, historical weights are more often used over marginal weights, which focus on current finance only, without a long-term view.

4.2. Market Value Weights

• Concept: Market Value Weights are based on current market value of the equity and debt.
• More Relevant: They are considered more relevant than book value weights because the value of each component is based on current value rather than historical value.
• More difficult to compute: These require more effort to calculate and therefore are not used as often as historical weights.
• They are based on actual market values and would better reflect the current cost of capital.

5. Mechanics of Computation

5.1. Example 1: Book Value Weights

Let's consider a firm with the following information:

(a) After-tax cost of capital for specific sources:

• Cost of debt: 8%
• Cost of preference shares: 14%
• Cost of equity funds: 17%

(b) Capital structure:

• Debt: Rs 300,000
• Preference capital: Rs 200,000
• Equity capital: Rs 500,000
• Total Capital: Rs 1,000,000

Table 1: Computation of Weighted Average Cost of Capital (Book Value Weights)

Source of Funds	Amount	Proportion	Cost (%)	Weighted Cost
Debt	Rs 300,000	0.3 (30%)	0.08	0.024
Preference Capital	Rs 200,000	0.2 (20%)	0.14	0.028
Equity Capital	Rs 500,000	0.5 (50%)	0.17	0.085
Total	Rs 1,000,000	1.00 (100%)		0.137

Weighted average cost of capital = 13.7%

5.2 Alternative Computation Method

An alternative method is to compute the total cost of capital and then divide by the total capital. This is a shorter process as it eliminates the need for fractional calculations.

6. Conclusion

The weighted average cost of capital (WACC) is a critical metric that takes into account all components of a company’s capital structure, and is used as the discount rate in capital budgeting and for overall assessment of a company. WACC must use weights based on proportions of each type of financing. When using historical weights, companies must decide between book values and market values. They must also take into account the fact that reliance on historical values may not always be the most effective option. Market weights are a better reflection of a company's current position, however, their computation is more complex.