Weighted Average Cost of Capital
Weighted average cost of capital is the average cost of the costs of several sources of financing. Weighted average cost of capital is also known as composite cost of capital, in general the cost of capital or average cost of capital. Once the particular cost of individual sources of finance is determined, we can calculate the weighted aver- age cost of capital by putting weight to the particular costs of capital in proportion of the various sources of funds to the total. The weights may be given either by using the book value of the source or market value of the source. The cost of capital calculated as per to the market value weight is generally higher than the book value weights and market value weights are sometimes preferred to the book value weights because the market value represents the true value of the investors.
Step 1: Calculate the Cost of the particular sources of funds (that is cost of debt/equity/preference capital, etc.)
Step 2: Multiply the cost of each source by its proportion in the capital structure.
Step 3: Add the Weighted component costs to get the firm's Weighted average cost of capital.