The weighted cost of capital can be computed by using the book value or the market value weights. If there were a difference between book value and market value weights, the weighted average cost of capital would differ according to the weights used. The weighted average cost of capital calculated by using the book-value weights will be understated if the market value of the share is higher than the book value and vice-versa. Besides the simplicity of their use, the book-value weights are said to have the following advantages:
- Firms in practice set their capital structure targets in terms of book values.
- The book-value information can be easily derived from the published sources.
- Investors to evaluate the riskiness of the firms in practice analyze the book-value debt-equity ratios.
But 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. The weights should also be market-determined. The book-value weights are based on arbitrary accounting policies followed to calculate retained earnings and value of assets. Thus they do not reflect 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 presumably 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 of securities fluctuate widely and frequently.
A third alternative, which is justified below, is to use target weights in the calculation of the overall cost of capital for evaluating the investment projects.
