WEIGHTED AVERAGE COST OF CAPITAL (WACC)
It is defined as the overall cost of capital or the average cost of various sources of financing employed by the company. When the capital of the company consists of funds raised from different sources enabling different costs.
The overall cost of capital of the company is calculated by giving weights to the cost of each source. The weights represent the proportion of each source of capital in the total capital of the company. An increase in Weighted Average Cost of Capital reflects higher risk.
COMPONENTS OF WACC
The components of the Weighted Average Cost of Capital are the specified costs of the different sources of funds that a company used for raising funds. They are as follows:
# COST OF EQUITY
It is the maximum rate of return that a firm must earn on the equity portion of total finance. Cost of equity is calculated in terms of future dividends to be paid on the shares. The cost of equity can be calculated using various approaches, they are as follows:
- Dividend Yield Method
- Dividend Plus growth Method
- Earning Price (E/P) Method
- Earnings Growth Method
- Realised Yield Method
# COST OF PREFERENCE CAPITAL
Cost of preference capital is defined as the dividend expected by preference shareholders. It is the annual preference share dividend divided by the net proceeds from the sale of preference shares. usually, cost of preference shares is calculated by two types, they are
Cost of redeemable preference shares
Cost of Irredeemable preference shares
# COST OF DEBT CAPITAL
Cost of Debt is defined as the after-tax cost of long-term funds through borrowings. The Cost of Debt is paid in the form of Interest to the debenture holders of the firm. The Cost of Debt is calculated in the following types,
- Cost of Redeemable Debt
- Cost of Irredeemable debt.
# COST OF RETAINED EARNINGS
The cost of retained earnings may be considered as the rate of return, which the existing shareholders can obtain by investing the after-tax dividends in the alternative opportunities of equal qualities.
# COST OF TERM LOANS
Term loans from financial or commercial banks represent debt capital which is usually repayable within 8 to 11 years in equal annual or half-yearly installments after an initial grace period of 1 to 4 years.