The Weightings
To calculate the weighted average cost of capital (WACC) we must take into account the weight of each component of a company's capital structure. To review, the equation for WACC is:
MVe stands for the market value of equity; MVd stands for the Market Value of Debt; Re stands for cost of equity; Rd stands for cost of debt; and t is the company's tax rate. If the person analyzing a company chooses or if the market value of a company's debt and equity is not available, the book value can be used.
The "weighting" varies based on how the company finances its activities. If the value of a company's debt exceeds the value of its equity, the cost of its debt will have more "weight" in calculating its total cost of capital than the cost of equity. If the value of the company's equity exceeds its debt, the cost of its equity will have more weight.
Market Value vs. Book Value
Since we are measuring expected cost of new capital, the calculation of weighted average cost of capital usually uses the market values of the various components rather than their book values. These may differ significantly.
Market value is the price at which an asset would trade in a competitive auction setting. It is the true underlying value of an asset according to theoretical standards. It is a distinct concept from market price, which is the price at which one can transact. For market price to equal market value, the market must be efficient and rational. Market value also requires the element of "special value" to be disregarded. Special value refers to a synergy that may exist between two parties that makes the fair price of a transaction higher.
Book value refers to the value of an asset according to the account balance present on the balance sheet of a company. The balance sheet is a summary of the financial balances of a company and is often described as a "snapshot of a company's financial condition. "
An asset's initial book value is its actual cash value or its acquisition cost. Cash assets are recorded or "booked" at actual cash value. Assets such as buildings, land, and equipment are valued based on their acquisition cost, which includes the actual cash cost of the asset, plus certain costs tied to the purchase of the asset, such as broker fees.
Domestic Balance Sheet
If the person analyzing a company chooses or if the market value of a company's debt and equity is not available, the book value can be used. The book value of debt and equity can be found on the company's balance sheet.