## Weighted Average Cost of Capital (WACC)
WACC is the blended cost of all capital sources, weighted by their proportions in the capital structure. It represents the minimum return a firm must earn on its investments to satisfy all capital providers.
### Formula
```
WACC = Σ (Wi × Ki)
```
Where `Wi` = proportion of source i and `Ki` = cost of source i
### Weights: Book Value vs Market Value
Book Value (BV) weights:
- Based on balance sheet figures
- Easier to compute
- Does not reflect current economic reality
- Can be misleading if market prices diverge significantly
Market Value (MV) weights:
- Based on current market prices of equity, preference shares, and debentures
- More accurate — reflects current cost of raising capital
- Preferred for decision-making and project evaluation
- Recommended by most theorists
### Treatment of retained earnings in weights
- In book value weights: retained earnings are shown separately
- In market value weights: retained earnings have no separate market value — they are already captured in the equity share price. Assign zero weight to retained earnings in MV weights.
### Steps to compute WACC
1. Find market value (or book value) of each source
2. Compute individual costs (Kd after tax, Kp, Ke, Kr)
3. Calculate weights = each source's value / total capital
4. WACC = Σ (Weight × Cost)
### Example 1
Q37 – PQR Ltd. WACC using Market Value Weights
Capital structure:
- Equity: 2,00,000 shares × ₹30 MPS = ₹60,00,000
- Reserves: included in equity market value
- 12% Pref: ₹10,00,000 (at book = assumed market)
- 9% Debentures: ₹30,00,000 (at book = assumed market)
Total market value = ₹1,00,00,000
Individual costs:
- Ke = D1/P0 + g = 3/30 + 0.07 = 10% + 7% = 17%
- Kp = 12% (no tax on pref dividends)
- Kd = 9% × (1−0.40) = 5.4%
| Source | MV (₹) | Weight | Cost | Weighted Cost |
|---|
| Equity+Reserves | 60,00,000 | 0.60 | 17% | 10.20% |
| Pref shares | 10,00,000 | 0.10 | 12% | 1.20% |
| Debentures | 30,00,000 | 0.30 | 5.4% | 1.62% |
| Total | 1,00,00,000 | 1.00 | | 13.02% |
### Example 2
Q38 – WACC before and after new borrowing
Existing structure:
- Equity: 6,00,000 shares × ₹600 = ₹36,00,00,000 = ₹36 cr
- 12% Debentures: ₹1.80 cr (at book, assumed par)
- Reserves: included in equity market value
Ke = D1/P0 + g
D0 = 24% × 100 = ₹24 per share; D1 = 24 × 1.05 = ₹25.20
Ke = 25.20/600 + 0.05 = 4.2% + 5% = 9.2%
Kd = 12% × (1−0.30) = 8.4%
Total MV = 36 + 1.80 = ₹37.80 cr
WACC = (36/37.80 × 9.2%) + (1.80/37.80 × 8.4%)
= 8.76% + 0.40% = 9.16%
After raising ₹3 cr @ 18% loan (new MPS = ₹500):
New equity MV = 6,00,000 × 500 = ₹30 cr
New Ke = 25.20/500 + 0.05 = 5.04% + 5% = 10.04%
Kd_new = 18% × 0.70 = 12.6%
Total MV = 30 + 1.80 + 3 = ₹34.80 cr
New WACC = (30/34.80 × 10.04%) + (1.80/34.80 × 8.4%) + (3/34.80 × 12.6%)
= 8.65% + 0.43% + 1.09% = 10.17%