Untitled-29

Cost of Capital^75

a. Issuing new equity share will increase the firm's weighted cost of capital

because external equity capital has a higher cost than internally generated

common equity.

b. As we use additional debt and preference shares, their cost may increase,

which will result in an increase in the weighted cost of capital.

c. The increase in the firm's weighted marginal cost of capital curve will occur

at the total rupee financing level when all the cheaper funding will be consumed

by the firm's investments, given the targeted debt- equity ratio. The increase

in the weighted cost of capital will occur when the total financing from all

sources equals:

Procedure for determining the weighted marginal cost of capital curve is given below
for ready reference.

1. Determine financial mix to be used.


2. Calculate the level of total financing at which the cost of equity capital increases.


3. Calculate the costs of each source of capital.


4. Compute the weighted marginal costs of capital at different levels of total financing.


5. Construct a graph that compares the internal rates of return of available investment
   projects with the weighted marginal costs of capital.

Calculation of Weighted average cost of capital

WACC basic computation is given by the formula given below

ko = ks 

D+E

E

+ kd [1-T] 

D+E

D

where:

ko = the weighted average cost of capital

ks = the cost of equity capital

kd = the before-tax cost of debt capital

T = the marginal tax rate

E/(D+E) = percentage of financing from equity

D/(D+E)= percentage of financing from debt

(D+E) = Total capital employed by the firm

In the formula above we are assuming that the capital has two components only, debt