CALCULATION OF THE COST OF CAPITAL
There are techniques to determine the total cost of capital that is used in the financial evaluation of the company. The main method of determining the appropriate total cost of capital is to find the average cost of capital using historical or marginal costs as a basis.
Average cost of capital
Average cost of capital is found by weighting the cost of each specific type of capital by the historical or marginal proportions of each type of capital that is used. Historical weights are based on the company's existing capital structure, while marginal weights consider the actual proportions of each type of financing expected when financing a given project.
Historical Weights
The use of historical weights to calculate the average cost of capital is quite common. The use of these weights is based on the assumption that the existing composition of funds, that is, their capital structure, is optimal and therefore should be sustained in the future. Two types of historical weights can be used:
Book Value Weights:
This assumes that new financing is obtained using exactly the same proportion of each type of financing that the company currently has in its capital structure.
Market value weights:
For financiers this is more attractive than the previous one, since the market values of the securities are closer to the real sum received from the sale of them. Furthermore, since the costs of different types of capital are calculated using prevailing market prices, it seems reasonable to use market value weights as well, however, it is more difficult to calculate the market values of sources of capital. Equity financing of a company that use book value.
Average cost of equity based on market value weights is typically higher than average cost based on book value weights, since most preferred and common stocks have market value that is much higher than average. Value in books.
Marginal Weights Using marginal
weights involves weighting the specific costs of different types of financing by the percentage of total financing expected to be achieved with each method of historical weights. By using marginal weights, it refers primarily to the actual amounts of each type of financing used.
With this type of weighting, you have a real project financing process and it admits that funds are actually obtained in different amounts, using different sources of long-term financing, it also reflects the fact that the company does not have much control over the amount of financing obtained with the surplus.
One of the criticisms made of the use of this system is that it does not consider the long-term implications of the current financing of the company.
