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Weighted Average Cost of Capital

Please assist with the following statements and question:

There are few ways to compute the weighted average cost of capital for a company: Of course one first estimates the 'cost' (in percentage terms) of the three main sources of capital: short term debt or liabilities, long term debt or liabilities and the cost of equity, and then computes the WACC using 'appropriate weights' as follows:

(1) Use the balance sheet of 'book values' of the different sources of capital as the 'weights'.

(2) Use the market value of short term debt (or liabilities), long term debt (or liabilities) and the market value of equity as 'weights'

(3) Use the "Target Capital Structure" of the company as the 'weights'.

Which of the three approaches should be adopted? Why?

Thanks in advance for your time and assistance!

Solution Preview

Weighted average cost of capital (WACC)
There are few ways to compute the weighted average cost of capital for a company: Of course one first estimates the 'cost' (in percentage terms) of the three main sources of capital: short term debt or liabilities, long term debt or liabilities and the cost of equity, and then computes the WACC using 'appropriate weights' as follows:
(1) Use the balance sheet of 'book values' of the different sources of capital as the 'weights'.
(2) Use the market value of short term debt (or liabilities), long term debt (or liabilities) and the market value of equity as 'weights'
(3) Use the "Target Capital Structure" of the company as the 'weights'.
Which of the three approaches should be adopted? Why?

Answer:
There are three different weighting systems:
? book value weights- least desirable
? market value weights
? target (optimal) capital structure weights- best
If optimal weights are available, they should be used- they are superior to the other systems. If optimal ...

Solution Summary

The solution evaluates the different ways to compute the weighted average cost of capital for a company- 1) balance sheet 'book values' of the different sources of capital as the 'weights' 2) market value of short term debt (or liabilities), long term debt (or liabilities) and the market value of equity as 'weights' and 3) "Target Capital Structure" of the company as the 'weights' and makes a recommendation on which method is to be selected.

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