Historical Weights
Historical weights interpret the weights attributed to several sources of finance based on the existing capital structure. The existing capital structure is regarded the base or the optimal capital structure and the relative weights are used.
The aspects applicable to the choice of appropriate weights are:
Historical weight Vs Marginal weights
Historical weight can be book value weights/ Market value weights.
Historical Vs Marginal weights
Weights are attributed to several sources of funds in the dimension which each source imparts to the total capital structure. The basis of these dimensions would be ascertained. There are 2 alternatives for this approach:
Marginal weighting
Historical weighting
The critical assumption in any weighting system is that the business firm will raise capital in the specified proportions. The first option to assign weights to several sources of financing for the purpose of computing the composite cost of capital is the system of marginal weights. The marginal weights interpret the percentage share of different financing sources the business firm intends to raise. The basis of assigning weight is thus,new or additional or incremental issue of funds and from that fact marginal weights. The second option is to assign weights based on the historical weights, either by selecting book-value weights or market-value weights.
There are few problems linked with historical weights. There is the main trouble of choosing between book value weights and market value weights. One of the major assumptions of historical weight is that the business firm should raise the new capital in the same proportion as its' existing capital structure. This may not always accommodate good. There may be an instance where the existing debt content is 30% and the business firm is unable to raise the same proportion by way of debt financing. There may not be adequate retained earnings to contribute the same way as it exists. Thus there are pragmatic troubles when looking at historical weights.
In spite of the fact that there are limitations in considering historical weights, it has the advantage of considering long-run implications which marginal weighting fails to consider. Thus in the long-run, historical weights leads to a selection of optimal capital structure and from that fact preferred over marginal weights.
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