Weighted Average cost of Capital

The minimum return from the performance of the asset that is expected to satisfy the creditors and investor is called weighted average cost of capital.  The company raise fund by many sources some of them are bonds, security, debt, liability etc. The company must be paying them back from the profit that it earned. The portion of the profit is given to the banks and other creditors by the company. The company must earn more than this percentage in order to meet up with some profit.

Weighted average cost of capital is given by the formula

Where cost of equity is termed as Re, cost of dept is termed as Rd, market value of the company equity is termed as E, market value of the company debt is termed as D, sum of E and D is termed as V, percentage of financing that is equity is termed as E/V, percentage of financing that is debt is termed as D/V, corporate tax is termed as Tc.

It can be interpreted that if weighted average cost of capital is 10% then the company must earn 10% of its asset value in order repay the banks and other creditors. Let us assume that the equity price of the company before profit declaration is 10 rupee, if the above condition is met the share price will remain at 10 rupee. If the company cannot earn the above 10 % return on asset then the share price will dip below 10 rupee. Finally if the company’s returns are more than 10% of the asset then the equity price of the security will increase.