The composite cost of capital, also known as the weighted average cost of capital (WACC), is a financial metric that represents the average rate of return required by a company to finance its operations and investments. It combines the cost of debt and the cost of equity capital based on their respective weights in the capital structure.
Here's how the composite cost of capital is calculated:
1. Determine the weight of debt and equity: The first step is to determine the proportion of debt and equity in the company's capital structure. This can be done by dividing the market value of debt and equity by the total market value of the company.
Weight of Debt = Market Value of Debt / Total Market Value of the Company Weight of Equity = Market Value of Equity / Total Market Value of the Company
2. Determine the cost of debt: The cost of debt is the interest rate or yield that the company is required to pay to its debt holders. It can be calculated by considering the current interest rate on existing debt or by estimating the interest rate the company would need to pay on new debt.
3. Determine the cost of equity: The cost of equity represents the rate of return expected by equity investors given the risk associated with the company. It is typically estimated using models such as the capital asset pricing model (CAPM) or the dividend discount model (DDM), taking into account factors such as the risk-free rate, market risk premium, and company-specific risk.
4. Calculate the composite cost of capital: Once the weight of debt and equity and the respective costs are determined, the composite cost of capital can be calculated using the following formula:
Composite Cost of Capital = (Weight of Debt * Cost of Debt) + (Weight of Equity * Cost of Equity)
The resulting percentage represents the average rate of return required by the company to satisfy the expectations of its debt and equity investors.
The composite cost of capital is used in financial decision-making, such as evaluating investment projects or determining the minimum required rate of return for capital budgeting. It serves as a benchmark for comparing the profitability of potential investments and assessing the overall cost-efficiency of the company's capital structure.
