Why Market Value Weights Matter More for WACC

Imagine a company as a big project, and to get that project running, you need money, right? Companies get this money from different places, mainly from borrowing, which we call debt, and from selling ownership shares, which is equity. Now, when we talk about the Weighted Average Cost of Capital, or WACC for short, we are essentially figuring out the average cost for a company to raise this money. It’s like calculating the average price you pay for a basket of groceries, where each grocery item has a different price, and you buy different quantities of each.

To calculate this average cost of capital, we need to know the ‘weights’ of each source of funding, meaning what proportion of the total money comes from debt and what proportion comes from equity. This is where the choice between book value and market value weights becomes crucial.

Think of book value as the historical cost recorded in the company’s accounting books. It’s like looking at the original price tag on something you bought years ago. For example, if a company issued shares a decade ago, the book value of equity would be based on the value recorded back then, maybe when the company was just starting out. Similarly, the book value of debt would reflect the original amounts borrowed. Book value is relatively easy to find, it’s readily available on a company’s balance sheet.

However, the business world is dynamic. Things change. The value of a company, and its shares, can fluctuate significantly over time due to various factors like company performance, economic conditions, and investor sentiment. This is where market value comes in. Market value, on the other hand, is like looking at the current selling price of something. For a company’s equity, market value is determined by the current stock price multiplied by the number of outstanding shares. For debt, it’s generally the present value of the company’s debt obligations, and often approximated by the book value if the debt is relatively recent and interest rates haven’t drastically changed. Market value is a much more current and forward-looking measure.

So, why is market value considered more appropriate for WACC calculations? The key reason is that WACC is used primarily for making decisions about the future. Companies use WACC to evaluate potential investments, to decide if a project is worth undertaking. When making these future-oriented decisions, we need to consider the current cost of raising capital, not the historical cost.

Think of it this way: if you were deciding whether to invest in a new project, would you base your decision on the historical cost of materials you bought years ago, or the current cost of those materials if you were to buy them today? You would definitely consider the current cost because that’s what you would actually pay. Similarly, for a company, the relevant cost of capital is what it would cost them to raise money today, not what it cost them in the past. Market value weights reflect the current market perception of the company’s risk and value, and therefore, the current cost of equity and debt.

Using book value weights can be misleading because they are often outdated and may not accurately reflect the company’s current capital structure or the expectations of investors. For instance, a company’s book value of equity might be significantly lower than its market value if the company has performed well and its stock price has risen. Using this lower book value weight for equity would underestimate the true proportion of equity financing and consequently skew the WACC calculation, potentially leading to incorrect investment decisions.

In essence, market value weights provide a more realistic and relevant picture of a company’s capital structure and the current cost of raising capital. They are forward-looking and reflect the opportunity cost of capital for investors in the current market environment. Therefore, when calculating WACC for investment appraisals and financial decision-making, using market value weights is generally considered a more accurate and appropriate approach than using book value weights. It ensures that the WACC reflects the current economic reality and provides a more reliable benchmark for evaluating investment opportunities.