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The Weighted Average Cost of Capital of the Company

Essay by   •  March 1, 2016  •  Essay  •  277 Words (2 Pages)  •  746 Views

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he company’s weighted average cost of capital of the company is 7.76% (round off). The weighted average cost of capital of the company has been taken as weighted average of cost of capital of equity and debt. The cost of capital of equity has been derived from the “Capital Asset Pricing Model”. As per the Capital Asset Pricing Model, Risk factor is added to the risk free rate of return to derive the cost of capital of the equity. Generally, risk free rate of return is the rate of return on government treasury. Risk factor is calculated by way of multiplying beta of the company with market premium. In the given case, risk free rate is 4%, market premium is 5.5% and beta of the company is 1.15. Therefore, cost of capital of equity as per Capital Asset Pricing Model is 10.325%. Cost of Debt has been taken as after tax as tax shield is available against interest expense. Interest paid to debt holders is deductible from profit for tax purpose. Therefore, it is appropriate to take after tax cost of debt for the purpose of calculating cost of capital of the company. The cost of debt, which has been assumed to be equal to current year to maturity return, in the given case, is 6.50% and tax rate is 40%. Therefore, after tax cost of debt is 3.90%. The ratio of debt to equity is 0.40. Therefore, we have assign weight of 0.40 to after tax cost of debt and weight of 0.60 to cost of equity to calculate cost of capital of the company. Therefore, Weighted Average Cost of Capital of the company is 7.76%.

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