Question

Explain how the three weighting methods (Market, Target, Book) differ and influence the WACC. Which is preferred? Justify why your choice is preferred?

Answer 1

There are three types of weighting methods which are based upon Market value,Target WACC, Book value.

1.Market value WACC- It is the price at which the asset would trade in a competetive auction setting. It is the true underlying value of an asset according to theoratical standards.The weights are based upon the market value of the debt and market value of the equity .Then the respective weights are multiplied with the respective cost to arrive at Cost of capital.

2.Book Value WACC- Book value refers to the value of an asset according to the account balance present on the balance sheet of a companty. The weighted average cost of capital are based upon book values and then they are multiplied with their respective cost to arrive at the Cost of capital.

3.Target WACC- It is used by assigning targeted weights to the debts as well as equity of the company .Then, the target weights are multiplied with the cost of respective capital to arrive at arrive at Targeted WACC.

They differs as they are based upon different types of values like book value, market value and target value.

I would prefer Book Value weights as they are highly stable and one can value the company based upon this form of WACC. In terms of valuation, Book value should be preferred as it is highly stable method and it can be reliable in comparison to market value which is highly fluctuating and Target value which involves a high level of forecasting.