this together amounts to composite cost. Again the source of funds may not be
used in equal proportions to form capital structure. In such a situation application
of WACC, rather than computing simple average cost, will be more reliable.5.3 To calculate WACC the cost of each source of funds must, firstly, be identified.
Secondly, the proportion of each source in the capital structure must be worked
out with the cost of each source. Thirdly, the weighted costs of all sources of
funds must be added. This sum is the weighted cost of capital. This shall be
obtained on the after-tax basis. While calculating WACC book-value weights or
market value weights, whichever is higher may be used.
5.4 In case of using new source of funds in a concern for the selection of a new
project, the cost of raising new funds has to be taken as the basis of calculation.
This is also known as the MCC (Marginal Cost of capital). The MCC is the cost
of raising an additional rupee of capital. The proportion of funds in capital
structure represents the marginal weights.
5.5 The proportion of funds from different sources in the capital structure is taken as
base to calculate the MCC.
5.6 The cost may increase as the level of borrowed funds increases. Up to a certain
level the cost on various sources of funds may remain constant and it may
increase after the particular level. This will give rise to average cost of capital
and the MCC will also rise.
5.7 Separate assignments will be given to participants to work out WACC in groups.
- CAP-M (Capital Asset Pricing - Model)
- 1 CAPM is a method of valuing assets to calculate the cost of capital. It explains
the movement of security prices. The CAPM approach helps investors assess the
impact of an investment on a proposed security within the entire portfolio with
reference to risk and return.
6.2 The CAPM approach is based on the assumption of efficient security markets and
investor preferences. Efficiency market means that the investors will have
common information about securities, including, Zero Taxes, Zero Restrictions on
Investments or No Transaction Costs. No single person can influence the market
price and all the investors will have common expectations. Preference will always
be in favour of a security that gives highest return, if risk levels are equal among
the given securities. If returns are equal, the investors will choose a low risk
security. The main assumption of CAPM is that investors are risk averse. Based
on this assumption, CAPM describes the risk required return as a trade off for
securities.