When estimating a weighted average cost of capital, a firm can use either book values or market values for estimating the value of the component sources of capital. Where would you find book values, and what value do they represent?
How would you calculate market values? In general, would you prefer to use market or book values for estimating the WACC? Under what circumstances would you use book values?
What will be an ideal response?
Answer: Book values for debt and equity are found on a firm's balance sheet and represent historical costs. Market values are calculated by multiplying the market price of the debt by the number of outstanding bonds and multiplying the number of outstanding shares of stock by the current market price. Market values represent the market's best estimate of the current value of future cash flows to be realized from owning debt or equity. In general we prefer to use market values because they are forward-looking rather than historical in nature. However, market values may not be available for privately held firms or for very small companies and then book value becomes the only practical, although inaccurate, alternative.
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