Thursday, April 15, 2010


Book Value VS Market value Weights

You should always use the market value weights to calculate WACC. In practice, firms do use the book value weights. Generally, there will be difference between the book value and market value weights, and therefore, WACC will be different. WACC, calculate using the book value weights, will be understand if the market value of the share is higher than the book value and vice versa.

Why do managers prefer the book value weights for calculating WACC?

Beside the simplicity of the use, managers claim following advantages for the book value weights:
  • Firms in practice set their target capital structure in terms of book values.
  • The book value information can be easily derived from the published sources.
  • The book value debt equity ratios are analyzed by the investors to evaluate the risk of the firms practice.

The use of the book value weights can be seriously questioned on theoretical grounds.

  1. The component costs are opportunity rates and are determined in the capital markets. Te weights should also be market determined.
  2. The book value weights are based on arbitrary accounting policies that are used to calculate retained earnings and value of assets. Thus they are not reflecting economic values. It is very difficult to justify the use of the book value weights in theory.
    Market value weights are theoretically superior to book value weights. They reflect economic values and are not influenced by accounting policies. They are also consistent with the market determined component costs. The difficulty in using market value weights is that the market prices securities fluctuate widely and frequently. A market value based target capital structure means that the amounts of debt and equity are continuously adjusted as the value of the firm charges.

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