Historical Weights
Historical weights represent the weights assigned to various sources of finance
based on the existing capital structure. The existing capital structure is considered
the base or the optimal capital structure and the relative weights are used.
The aspects relevant to the selection of appropriate weights are:
- Historical weight Vs Marginal weights
- Historical weight can be book value weights or Market value weights.
Historical Vs Marginal weights
Weights are assigned to various sources of funds in the proportion which each source
contributes to the total capital structure. The basis of these proportions would
be determined. There are two alternatives for this:
- Marginal weighting
- Historical weighting
The critical assumption in any weighting system is that the firm will raise capital
in the specified proportions. The first alternative to assign weights to various
sources of financing for the purpose of calculating the composite cost of capital
is the system of marginal weights. The marginal weights represent the percentage
share of different financing sources the firm intends to raise. The basis of assigning
weight is therefore, new/additional/incremental issue of funds and hence marginal
weights. The second alternative is to assign weights based on the historical weights,
either by choosing book-value weights or market-value weights.
There are few problems associated with historical weights. There is the main problem
of choosing between book-value weights and market-value weights. One of the major
assumptions of historical weight is that the firm should raise the new capital in
the same proportion as its’ existing capital structure. This may not always hold
good. There may be an instance where the existing debt content is 30% and the firm
is unable to raise the same proportion by way of debt financing. There may not be
enough retained earnings to contribute the same way as it exists. Thus there are
practical difficulties when considering historical weights.
Though there are limitations in considering historical weights, it has the advantage
of considering long-run implications which marginal weighting fails to consider.
Thus in the long-run, historical weights leads to a selection of optimal capital
structure and hence preferred over marginal weights.
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