Weighted Average Cost of Capital

Overview of Weighted Average Cost of Capital
The concept of weighted average cost of capital is one of the most important ones in the context of finance. It is extensively used for the purpose of determining the cost of capital incurred by a particular business entity in its operations.

Use of Weighted Average Cost of Capital
The weighted average cost of capital is normally used to provide the assumed cost of new capital of a particular business entity. The theory of weighted average cost of capital has been used as a form of rate of discount for business undertakings that have been financed.

The main reason behind this use of the weighted average cost of capital is the fact that many think the cost of capital of a company to be like a proper rate of discount as far as usage of that is concerned.

Description of Weighted Average Cost of Capital
In its calculations the weighted average cost of capital normally considers both the sources of a company’s collection of financial resources – debt and equity. Weighted average cost of capital could be described as the amount of income a particular company has to make on the assets it has.
The main reason for such a necessity is the fact that this helps the companies to maintain a fixed price of their shares in the market. The companies can also live up to the expectations of the lenders.
Equational Representation of Weighted Average Cost of Capital
The following is a numerical presentation of the weighted average cost of capital:

c = (E/K).y + (D/K). b(1 – tc/100)

In this formula:

K = D + E
c represents the weighted average cost of capital
D represents the entire amount of leases and debts taken by a company.
y represents the necessary or assumed return rate on equity. It could also be called the cost of equity.
E represents the entire value in the market of the equity and such other assets that are possessed by the company.
b represents the cost of debt, which is the assumed or needed return rate on the various debts.
K represents the entire amount of money that has been put in the present business.
|c represents the corporate rate of taxes.

 

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Last Updated on : 27th June 2013

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