Weighted Average Cost of Capital (WACC) is defined as the weighted average of cost of each component of capital (equity, debt, preference shares etc) where the weights used are target capital structure weights expressed in terms of market values. We will discuss the difference between book value WACC and market value weights and why market value weights are preferred over book value weights. It is assumed that the primary purpose of WACC is to evaluate new projects.
Different Types of Weights
The weights can be historical or marginal and further historical weights can have either book values or market values of capital components. Therefore, three possible types of weights are discussed below with the help of following table of calculations:
Marginal Vs. Historical Weights
These are the proportion of capital in which the fresh capital for the new project is raised. In the table below, we can notice that funds are raised for the new project in the ratio of 1:7:2 (Equity: Debt: Preference) and these proportion are used to calculate the WACC. We can observe that the WACC is the lowest compared to other two weighting approaches and it is also visible that the reason is the higher proportion of debt in the capital structure.
There is a direct link between the project and the financing arrangement. The actual or relevant money that is going to be used for implementing the project is the money marginally raised in the ratio.
It is a very short term approach. It is not considering leverage effect of financing the current project. The WACC in marginal weights is low because of too high debt in the structure which compromises the debt-equity ratio of the company. When the same company will raise money next year for some other project, they will have to take more equity finance because of already higher debt-equity ratio. That time, the WACC will be much higher compared to this situation.
Currently, WACC is 11.8% and a project having returns of 12.25% will be accepted. Next year WACC will be say 15% due to higher equity participation. A good project having a return of 14% will be rejected. This approach is not consistent and therefore, historical weights should be preferred over marginal weights.
These are the proportion of actual existing capital structure in terms of book value or market value. Historic weights assume that the firm will finance its future projects in the existing capital structure and it is the optimum structure.
The advantage of historic weights over marginal weights is that it takes a longer term in view which supports the going concern concept and conservative approach. The WACC of 14.25% (Book Value) or 15.67% (Market Value) will remain more or less consistent.
Raising the finance at a predefined ratio is very difficult in the market and not in our control. There are a lot of economic and other factors affect availability and cost of finance.
The acceptance and rejection criterion in historical weights will not fluctuate like a pendulum but that is possible in case of marginal weights. Looking at the consistency and long-term view of the approach, we should use historical weights.
We have concluded historical weights between marginal vs. historical weights based on above discussion, the next step is to zero down between book value and market value.
|[–||Marginal Weights||–]||[–||Historical Book Value Weights||–]||[–||Historical Market Value Weights||–]|
|Particulars||After Tax Cost of Capital||Marginal Capital||Prop-ortion||WACC||Book Value||Prop-ortion||WACC||Market Value||Prop-ortion||WACC|
Market vs. Book Value Weights
Book Value WACC is calculated using book value weights whereas the Market Value WACC is calculated using the market value of the sources of capital. Why the market value weights are preferred over book values weights:
The book value weights are readily available from balance sheet for all types of firms and are very simple to calculate. On the other hand, for Market Value weights, the market values have to be determined and it is a real difficult task to acquire accurate data for the same especially the value of equity when the entity is not listed. Still Market Value WACC is considered appropriate by analysts because an investor would demand market required rate of return on the market value of the capital and not the book value of the capital.
Assume a firm issued capital at $10 per equity share 5 years back. Current market value of the share is $30 and book value is $18 and market required rate of return is 20%. The investors (existing and new) of the company will expect a return on $30 and not $18. Let us see how a rational investor will behave.
He can buy the share of the company at $30 from the market. If the firm returns 20% on book value i.e. $3.6. The new investor will calculate his percentage of gain 12% (3.6/30) which is far less than 20%. Why 30 dollar because the investment by him is 30 and not 10 or 18.
Since, market required rate of return is 20% and return on investment at current prices is only 12%, a better situation for existing investor would be to sell off the securities at $30 and invest in other securities giving more than 12% return. The existing investor will exit from the investment considering it an overpriced stock and invest in securities which are underpriced or appropriately priced by the market.
The market value weights are appropriate compared to book value weights. Hence, historical market value weights should be used for calculation of WACC out of the three options – marginal weights, historical book value weights, and historical market value weights.