WACC denotes the Weighted Average Cost of Capital. It is also known as Overall Cost of Capital. As the name suggest, it is computed by reference to the proportion of each element of capital as weights. WACC is the expected average future cost of finance over the long run of firm.

 Weighted Cost of Capital of Overall Cost of Capital represented symbolically by Ko

 WACC = Sum of (Cost of each Capital Element × Proportion or percentage or weight of Capital)

The calculation of Weighted Average Cost of Capital or Overall Cost of Capital involves the following steps:-

  • Determine the cost of each source of capital separately i.e. Cost of Equity Capital, Cost of Debt, Cost of Preference Capital, Cost of Retained Earning, Cost of Loan, Cost of any other finance. 
  • Determine the weight of each source of capital. 
  • Multiplying the cost of each of the source by appropriate weights. and 
  • Dividing the total weighted cost by total weight.

Format of calculation of WACC

Source of Capital

Proportion or %

Each Element Cost

Multiplication

Equity Capital

W1

Ke

W1 × Ke

Pref Share Capital

W2

Kp

W2 × Kp

Debt

W3

Kd

W3 × Kd

Retained Earning

W4

Ke

W4 × Ke

Total

100



Sum of above
WACC = Sum of above / 100

Therefore WACC is the average cost of the company’s finance, equity, debenture, bank loans weighted according to the total pool of capital.

In case of selection of weight, there are two main aspects relevant to the selection of appropriate weight are (1) Marginal weight and (2) Historical Weight

Marginal Weight: - marginal weight is the proportion of different source of fund additionally raised for new investments. As the proportion of different source are not equal, so weighted average marginal cost of capital is to be computed for investment decision.
Historical Weight:- Historical weight is the proportion of source of finance. Historical weight also divided into two category i.e. (1) Book Value of weight and (2) Market value of weight



Now the question arise that which system of weighting – marginal or historical is preferable. 
Marginal weight is widely used because WACC and Marginal Weight both focus in the future project. The alternative to the use of marginal weight is to be use of historical weight. Again the problem is to be faced as to which weight are to be consider book value weight or market value of weight in case of historical weight. Generally market value of weight is considered because it reflects the current market value or condition. If the company or firm is not listed or not traded in the stock exchange, it is not possible to determine the market value. Hence the book value of weight is to be considered.

Importance or Significance of Weighted Average Cost of Capital (WACC) or Overall Cost of Capital:-
  • in case of determination of future project profitability, WACC is treated as Cut off rate
  • if firm earn more percentage of profit than WACC, therefore the market value of the firm will increased. Profit taken or not decision is depending on this point. A project considered valuable only if the return from it re higher than WACC.
  • Business unit used different source of finance and invested in the project. So individual cost of capital is not enough for project selection process. Therefore overall cost of capital is considered for project selection process.
  • WACC is widely used to selection project among the option available.
  • WACC is useful in making Economic value Added (EVA) calculation.
  • WACC indicate the minimum rate of return at which business unit create the investors value. If Return on Capital Employed (ROCE) is higher than WACC, business unit will create the investors value, otherwise business unit will fail to create the investors value.

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Pijush Roy, Founder & Author of "Share Your Knowledge", is a young freelance blogger, a reader, a painter, .....read more


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