When calculating the weighted average cost of capital (WACC), the weights assigned to debt and equity can materially change the answer. The central question is whether those weights should come from accounting book values or current market values.
WACC formula
For a company financed by ordinary equity and interest-bearing debt:
WACC = (E ÷ V)Ke + (D ÷ V)Kd(1 − T)
- E = market value of equity
- D = market value of interest-bearing debt
- V = E + D
- Ke = cost of equity
- Kd = pre-tax cost of debt
- T = corporate tax rate
Review the complete weighted average cost of capital lesson for the broader calculation.
What are book value weights?
Book values are accounting figures reported in the statement of financial position. Book equity is based on contributed capital and accumulated reserves, while book debt is the carrying amount recognised under accounting rules.
They are easy to obtain and relatively stable, but they describe historical financing transactions. They may differ greatly from the amount investors currently place at risk.
What are market value weights?
Market values estimate the current economic value of each financing source. For a listed company, market equity is normally:
Market value of equity = Current share price × Shares outstanding
Market debt is the present value or quoted price of outstanding debt. When reliable debt prices are unavailable and the debt is recent, its book value may sometimes be a reasonable approximation—but that assumption should be disclosed.
Worked example: book weights versus market weights
Assume a company has the following financing:
| Source | Book value | Market value | After-tax cost |
|---|---|---|---|
| Debt | $400,000 | $350,000 | 6% |
| Equity | $600,000 | $900,000 | 12% |
Using book value weights
Debt weight = 400,000 ÷ 1,000,000 = 40%
Equity weight = 600,000 ÷ 1,000,000 = 60%
Book-value WACC = (40% × 6%) + (60% × 12%) = 9.60%
Using market value weights
Debt weight = 350,000 ÷ 1,250,000 = 28%
Equity weight = 900,000 ÷ 1,250,000 = 72%
Market-value WACC = (28% × 6%) + (72% × 12%) = 10.32%
Using book weights understates the current cost of capital by 0.72 percentage points. That difference could cause the company to accept a project that does not earn the return required by today’s investors.
Why market value weights are normally preferred
- WACC is forward-looking. It estimates the current return required by capital providers.
- Market values represent current opportunity costs. Investors could sell their securities at current prices and invest elsewhere.
- Book equity can be stale. Historic issue prices and retained earnings may bear little relationship to current value.
- Investment decisions use current risk. Current capital proportions are more consistent with current costs of debt and equity.
When book values may be used
Book values may be necessary for a private company with no observable equity price, illiquid debt, or insufficient market evidence. In that case, analysts can improve the estimate by using:
- valuation multiples from comparable listed companies;
- a professional business valuation;
- recent financing transaction values;
- industry-average or target capital structures; and
- book debt as a disclosed proxy when it closely approximates market debt.
Current weights or target capital structure?
For project appraisal, a stable target market-value capital structure can be better than a temporary current mix. A company may currently carry unusually high debt after an acquisition or unusually high equity after a share issue. Management’s sustainable long-run financing policy may better represent how future projects will be funded.
Project risk also matters. A divisional or project-specific discount rate may be required when the investment differs from the company’s existing operations. See cost of capital for projects.
Common WACC weighting errors
- mixing market-value equity with book-value debt without explaining the approximation;
- including non-interest-bearing trade liabilities as if they were long-term financing;
- using the historic interest rate instead of the current cost of existing debt;
- ignoring preference shares, leases or convertible securities;
- using negative book equity as a meaningful weight;
- forgetting the tax adjustment on eligible debt interest; and
- using the company WACC for a project with materially different risk.
Frequently asked questions
Does WACC use book value or market value?
Use market value weights when reliable data is available. Book values are a fallback or approximation.
Why is book value usually wrong for equity?
Book equity records historical accounting transactions, while the cost of equity reflects the return currently required by investors.
Can book value of debt approximate market value?
Sometimes—particularly for recent, floating-rate or short-maturity debt. The approximation becomes weaker when interest rates or credit risk have changed significantly.
Should WACC use current or target weights?
Use target market weights when they credibly represent the sustainable long-term financing policy used for future projects.
How is the cost of equity estimated?
Common approaches include the dividend growth model and the capital asset pricing model.
Continue learning: review the cost of capital and follow the Cost of Capital and WACC learning path.
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.
- The component costs are opportunity rates and are determined in the capital markets. Te weights should also be market determined.
- 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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