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Should I use book value weights or market value weights while calculating WACC?

GradeHunt_TeamGradeHunt Team · · CA Intermediate

In CA Inter FM, some WACC questions give both book values and market values of equity and debt. Which weights should I use if the question does not say?
wacccost of capitalmarket value weightsfm

1 answer

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Use what the question asks for. If it asks for both, calculate both. If it is silent, market value weights are the better answer in theory, but read the data carefully. Why market value weights are preferred: - WACC is used to evaluate new investments, so the weights should reflect the current value of each source of finance, which is its market value. - Book values reflect history (face value plus reserves such as share premium and retained earnings) and can be far from current values. Why book value weights are still used: - They are easy to get from the balance sheet and stay stable. - Many companies set a target capital structure on book values. Points to remember in calculation: 1. With book value weights, retained earnings are a separate source at their book value. With market value weights, retained earnings have no separate market value, because the market price of equity shares already includes them, so never add retained earnings on top of the market value of equity. If the question gives a different cost for retained earnings (Kr) and for equity (Ke), split the total market value of equity between equity capital and retained earnings in the ratio of their book values, as the ICAI study material does. For example, if book values are equity capital Rs 120 lakh and retained earnings Rs 30 lakh (4:1) and the market value of equity is Rs 200 lakh, use Rs 160 lakh for equity and Rs 40 lakh for retained earnings. 2. Use the after-tax cost of debt. Irredeemable debt: Kd = I(1 - t) / NP. Redeemable debt: Kd = [I(1 - t) + (RV - NP)/n] / [(RV + NP)/2], where I is the annual interest, t the tax rate, NP the net proceeds or current market price, RV the redemption value and n the years to redemption. 3. Market value WACC is usually higher than book value WACC when shares trade above book value, because equity (the costliest source) gets a bigger weight. Exam tip: if the question gives the market price per share and the number of shares, it is giving you the data for market value weights, so use it. If you calculate both, write a short note at the end comparing the two results and explaining why they differ.
GradeHunt_TeamGradeHunt Team · 0 pts ·