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COMPUTATION OF OVERALL COST OF CAPITAL

The calculations of the cost of specific sources, namely, debt, preference shares, equity shares and retained earnings have been shown in the preceding discussions. In this section we propose to dwell on the computation of the overall cost of capital. The term cost of capital means the overall composite cost of capital defined as weighted average of the cost of each specific of cost. The use of average and not the simple average is warranted by the fact that the proportions of various sources of funds in the capital structure of a firm are different. To a representative, therefore, the overall cost of capital should take into account the relative proportions of different sources and hence the average. The computation of the overall cost of capital (represented symbolically by k) involves the following steps:

1. Assigning weights to specific costs.

2. Multiplying the cost of each of the sources by the appropriate weights.

3. Dividing the total weighted cost by the total weights.

4. The crucial pan of the exercise is the decision regarding appropriate weights and the related aspects. We first illustrate the relevant aspects of the choke of the weights. This is followed by the mechanics of computation of ko which is relatively simple.