Composite Costs of Capital

Composite Costs of Capital

The cost of capital of a firm may be defined as a weighted average of the cost of each type of capital. Because the firm is valued as an overall entry, it is inappropriate to associate specific methods of financing with specific investment opportunities. Thus, as focus is on the valuation of the firm as a whole, we must use an overall, composite cost of capital as the acceptance criterion. It is the overall mix of financing that is important.

A company has to employ a combination of creditors and owners funds. The composite cost of all capital lies between the least and the most expensive funds. This approach enables the maximization of corporate profits and shareholders wealth by investing funds in project earning in excess of the cost of its capital mix.

The computation of weighted average cost is the practical application of this approach. The weight for each type of capital is the ratio of either (i) the book value of (ii) the market value of the funds/securities representing that source of capital to the total value of all funds of the company.