Once the component costs have been calculated, they are multiplied by the proportions of the respective source of capital to obtain the weighted average cost of capital (WACC). The proportions of capital must be based on target capital structure. WACC is the composite or overall cost of capital. You may note that it is the weighted average concept, not the simple average, which is relevant in calculating the overall cost of capital. The simple average cost of capital is appropriate to use because firms hardly use various sources of funds equally in the cost of structure.
The following steps are involved for calculating the firm’s WACC:
- Calculate the cost of specific sources of funds
- Multiply the cost of each source by its proportion in the capital structure
- Add the weighted component costs to get the WACC
In financial decision making, the cost of capital should be calculated on tax after basis. Therefore, the component costs should be after tax costs. If we assume that a firm has only debt and equity in its capital structure, then the WACC (Ko) will be:
Ko = (Kd (1-T)wd) + (KeWe)
Ko =Kd (1- T)(D/D+E) + Ke (E/D+E)
Where Ko is the WACC, Kd(1+T) and Ke are, respectively, the after tax cost of debt and equity, D is the amount of debt and E is the amount of equity. In a general form, the formula for calculating WACC can be written as follows:
Ko = K1w1+K2w2+-----------------
Where K1, K2 ----------are component costs and w1, w2------------weights of various types of capital employed by the company
Weighted marginal cost of capital (WMCC)
Marginal cost is the new or incremental cost of new capital (equity and debt) issued by the firm. We assume that new funds are raised at new costs according to the firm’s target capital structure. Hence, what is commonly known as the WACC is in fact the weighted marginal cost of capital (WMCC); that is, the weighted average cost of new capital given the firm’s target capital structure.
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