Weighted Average Cost of Capital (Weighted Average Cost of Capital )
The weighted average cost of capital evaluates the capital discount of a company's income and expenditure. It is a component of the formula employed for computing the anticipated cost of new capital and it comprises the rate that a company is anticipated to pay to finance its assets. It is thus the minimum return that a company must earn on its existing asset base to satisfy its owners, creditors and other providers of capital.
Weighted Average Cost of Capital is computed by taking into account the relative weight of each component of a company's capital structure. The computation in general employs the market values of the components, rather than their book values, which may differ significantly. Components may let in equity i.e. both preferred and common, debt i.e convertible, straight, warrants, exchangeable, options, executive stock options, government subsidies and pension liabilities. More alien sources of financing, such as callable bonds, convertible or convertible preferred stock may also be admitted in a Weighted Average Cost of Capital computation if they are present in substantial amounts as the cost of these is In general different from plain vanilla financing methods. For a company with a complex capital structure, computing Weighted Average Cost of Capital can be a time-consuming exercise.
The equation employed to compute Weighted Average Cost of Capital employs the cost of each capital component multiplied by its proportional weight as follows:
Weighted Average Cost of Capital = E/V × Re + D/V × Rd × (1 - Tc)
where Re is the cost of equity, Rd is the cost of debt, E is the market value of the firm's equity, D is the market value of the firm's debt, V = E + D, E/V is the percentage of financing that is equity, D/V is the percentage of financing that is debt, and Tc is the corporate tax rate.
To determine the value of each component it is presumed that the weight of a source of financing is simply its market value rather than the book value, which may be significantly dissimilar divided by the sum of the values of all the constituents. The easiest component to compute is the market value of the equity of a publicly traded company, as this is merely the price per share manifolded by the number of prominent shares. Likewise, the market value of preferred shares is easy to determine and is computed by multiplying the cost per share by number of outstanding shares. The market value of a company's debt is also comfortable to discover if a company has publicly traded bonds. On the other hand, many companies have debt in the form of bank loans, whose market value is not easily found. On the other hand, the market value of debt is oftentimes fairly close to the book value, at least for companies that have not went via substantial variations in credit rating. Thus, computation of Weighted Average Cost of Capital typically employs the book value of any debt.
On the cost side, the cost of preferred shares is computed by dividing the periodic payment by the price of the preferred shares. The cost of ordinary shares is typically ascertained employing the capital asset pricing model. The cost of debt is In general the yield to maturity on the company's publicly traded bonds, or the rates of interest charged by the banks on recent loans. The cost of debt can be cut further as a company can In general write off taxes on the interest it pays on the debt. Thus, the cost of debt is computed as yield to maturity multiplied by 1 minus the tax rate.
Due to governments In general allow tax to be deducted from interest, there is an inherent bias towards debt financing. On the other hand, the cost of financial distress, such as bankruptcy, tilts any bias towards equity financing. In theory, thus, the ideal debt to equity ratio in a company is in general the point at which any tax benefits accrued by debt financing are outweighed by the monetary value of financial distress.
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