Historical Weight

The alternative to the use of marginal weights is to use historical. Here, the relative proportions of various sources to the existing capital structure are used weights. In other words, the basis of the weighting system is the funds already employ firm. The use of the historical weights is based on the assumption that the firm’s structure is optimal and, therefore, should be maintained in the future. That is, the raise additional funds for financing investments in the same proportion as they are in the capital structure. In other words, the existing proportion of various sources of long-term be followed whenever the firm raises additional long-term funds to finance new projects. For instance, if the present capital structure of firm has 30 per cent debts, preference shares, 40 per cent equity capital and 10 per cent retained earnings, the can be assumed to raise incremental funds in the same proportion as it has done in the further, that the firm requires additional funds amounting to Rs 1,00,000 to finance. It should be expected, according to the historical weighting system, to raise this sum sources in the proportion of 30 per cent (debt), 20 per cent (preference shares, ordinary shares) and 10 per cent (retained earnings). The break-up of the amount would be debt, Rs 30,000; preference capital, Rs 20,000; equity capital, Rs 40,000 earnings, Rs 10,000.

As against the above limitations, the term of as (weights on the basis of the existing capital structure) has one outstanding merit. As a decision criterion, the weighted cost of capital based on historical weights takes into account a long-term view. If the cost thus calculated is 12 per cent, using it as a decision-criterion for capital budgeting decision a project returning 13 per cent next year will be accepted. While it is true that firms actually raise funds in lump sum amounts from one or two sources at a time instead of all the available sources, the use of historical weights to calculate the overall weighted average cost of capital is more consistent with the firm’s long-term goal of maximizing the owner’s wealth. Therefore, the use of historical weights is much more likely to lead to an optimal selection of capital investment projects in the long run. It is probably for this reason that historical weights are commonly used to calculate the weighted cost of capital, and are treated as superior to marginal weights, which, as already indicated ignore the long-term implications of the firm’s current financing.

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