A Weighted Average Cost of Capital - Business Finance - ثاني ثانوي

8.2 A Weighted-Average Cost of Capital Key Terms Capital structure Weighted average cost of capital Nearly every company uses a combination of debt and equity to finance its assets. This mixture of funding sources is the capital structure, which is the amount of debt and equity used by a company to finance its business activities. The capital structure of the company is used to calculate the weighted average cost of capital. This is a weighted average of the costs of debt, preferred stock, and common stock. The weights depend on the proportion of the firm's assets financed by each source. Management should determine the optimal combination of the various sources to minimize the weighted-average cost of funds and maximize the value of the firm. Determining the firm's optimal capital structure requires understanding of how the weighted-average cost of funds is derived. The weighted-average cost of capital is calculated by multiplying the proportions of debt and equity times the capital cost for each of them. EXAMPLE If a company with no preferred stock has 30% debt at a cost of 8% and 70% equity at a cost of 10%, the weighted-average cost of capital would be: = (Percent Debt x Cost of Debt) + (Percent Equity x Cost of Equity) = (0.30 x 0.08) + (0.70 x 0.10) = 0.024+0.07 0.094 = 9,4% www.dem.edu.sa Capital structure The amount of debt and equity used by a company to finance it business activities wwiched-average res of capital The mean of the costs of debt, shares in alium that pay dividends, and common stock You might think that the weighted average cost of capital declines as a company takes on more debt. This is true, but only up to a certain portion of debt. As more debt is used, risk increases to create a higher cost of both debt and equity, resulting in a higher weighted average cost of capital. Every organization attempts to minimize its cost of capital. This will occur when an appropriate combination of debt and equity is used. The exact combination will vary for every company and changes as risk (from increased use of debt) and interest rates change. Managers continually analyze various economic and company factors to arrive at the optimal capital structure. وزارة التعليدر CHAPTERY Cost of Capital 331

How might a financial manager try to minimize the cost of capital? 332Business Finance 2921-185 Management has calculated that the current cost of each type of financing is: Cost of debt Cost of preferred stock Cost of common stock (retained earnings) 5.20% 8.96% 11.00% The proportion (the weights) of the firm's assets financed by each type of financing is: Debt 40% Preferred stock 10% Common stock (retained earnings) 50%

Note that the total of the proportions should add up to 100%. To find the cost of capital, multiply the proportion of each component of the optimal capital structure by its respective costs and add the results. For this firm, it yields: Cust Weight = Weighted Cont Debt Preferred Stock Common Stock 520% 0,40 = 2.080% 8.96% x 0.10 = 0.896% 11.00% > 0.50 = 5.500% 8476% The process of determining the cost of funds is: k=wik, +wik + wik Cost of capital The equation states that the cost of capital (k) is a weighted average in which the costs of debt (ka), preferred stock (k), and equity (k,) are weighted by the extent to which they are used (that is, w, w, and w,, respectively). These weights, along with the cost of each source, then determine the overall cost of funds. In the above illustration, the cost of capital is: k=(0.4)5.20+ (0.1)8.96 + (0.5)11.00 = 0.08476 = 8.476% For this firm, the weighted average cost of capital is 8.476%. The firm must earn at least 8.476% on its business activities to justify using these sources of financing. You Try It What would be the weighted-average cost of capital in this situation? debt: 30% common stock: 60% preferred stock 10% cost of debt: 7% cost of common stock: 11% cost of preferred stock: 9.5% وزارة التعليم CHAPTER Cost of Capital 333

334Business Finance . Exercises Choose the correct answer. 1. A firm entirely financed by common stock with no debt has a weighted average cost of capital equal to the cost of equity. True/False 2. In the weighted average formula, the least expensive financing source will be the: a. cost of debt. b. cost of preferred stock. c. cost of common stock. d. risk premium.