by Cost of Capital is the minimum rate of return a company must earn on its investments to maintain its market value and satisfy its investors. It represents the opportunity cost of using funds for a specific project rather than for alternative investments with comparable risk. It is not a single figure but a blended rate reflecting the cost of each source of finance (debt, equity, preference shares) used by the firm.
WACC is the firm’s overall cost of capital, calculated by taking the average of the costs of each source of financing (debt, equity, preference), weighted by their proportion in the company’s total capital structure. It serves as the critical discount rate for evaluating new investments and corporate valuation. A project must generate a return higher than the WACC to create shareholder value.
Hypothetical Data
| Source of Capital | Amount (₹ in lakhs) | Cost (%) |
|---|---|---|
| Equity Shares | 50 | 12% |
| Preference Shares | 30 | 10% |
| Debt (Bank Loan) | 20 | 8% (after tax) |
Total Capital = 50 + 30 + 20 = 100 lakhs
Step 1: Calculate Weights of Each Source
Weight of Equity = 50 / 100 = 0.50
Weight of Preference Shares = 30 / 100 = 0.30
Weight of Debt = 20 / 100 = 0.20
Step 2: Calculate Weighted Cost
Weighted cost of Equity = 0.50 × 12% = 6%
Weighted cost of Preference Shares = 0.30 × 10% = 3%
Weighted cost of Debt = 0.20 × 8% = 1.6%
Step 3: Calculate WACC
WACC = Sum of weighted costs
WACC = 6% + 3% + 1.6% = 10.6%
✅ Interpretation
The firm’s average cost of capital is 10.6%. This means any investment should earn more than 10.6% to create value for shareholders.
