Composite Cost of Capital

The composite cost of capital is the weighted average cost of all the sources of funding used by a company to finance its operations and growth. It takes into account the costs of both debt and equity financing and is calculated based on the proportion of each source of funding in the company’s capital structure.

To calculate the composite cost of capital, the company first needs to determine the proportion of each source of funding in its capital structure. This can be done by calculating the percentage of debt and equity financing in the total capital employed.

Once the proportion of each source of funding is determined, the cost of each source of funding is calculated separately. The cost of debt is calculated based on the interest rate and any other costs associated with the debt, such as fees and expenses. The cost of equity is calculated based on the expected return required by equity investors, which can be estimated using the capital asset pricing model (CAPM) or other similar methods.

The composite cost of capital is then calculated by multiplying the proportion of each source of funding by its respective cost and summing the results. The formula for calculating the composite cost of capital is:

Composite Cost of Capital = (% Debt x Cost of Debt) + (% Equity x Cost of Equity)

The composite cost of capital is an important measure for companies, as it represents the overall cost of financing and can be used to evaluate the profitability of potential investment projects. Companies typically seek to minimize their composite cost of capital by optimizing their capital structure and selecting the most cost-effective sources of financing.