Illustrate the concept of average cost of capital with the help of an example?
3 years ago
Financial Management
A firm’s cost of capital is the weighted arithmetic average of the cost of different sources of long term finance used by it. Let us assume a company uses equity costing 16% and debt costing 9%. If the proportions in which debt and equity are used are respectively 40% and 60% the cost capital would work out to:
Cost of capital = Proportion of equity x Cost of equity + Proportion of debt x Cost of debt
= 0.40 x 16% + 0.60 x 9%
= 6.4% + 5.4% = 11.80%
Generalising, if the firm uses different sources of capital then the Average cost of capital would be:
Ka = S Pi Ki
where
Ka = Average cost of capital
Pi = Proportion of the i th sources of finance
Ki = Cost of the i th source of finance.
Sanisha Maharjan
Jan 18, 2022