Question

explain why book values should not be used to evalute costs of capital

Answer 1

The main reason for this is that book values can be different from actual market values of debt & especially of equity share capital. Since stock markets are volatile, there can, at times, be a huge difference between the book value of the equity of a firm & its market value which is based on the prevailing stock price. Thus using book values for the cost of capital evaluation can introduce serious flaws in the analysis leading to potentially wrong decisions.

For example, on a book value basis, the debt-to-capital ratio of Caterpillar was around 79% at the end of 2016. As, on a book-value basis, Caterpillar had about $49.5 billion of debt versus equity of $13.1 billion, but it's market capitalization (stock price times the number of shares outstanding) was around $53.3 billion. So on a market-value basis, Caterpillar’s debt-to-capital ratio was only $49.5/($49.5 1 $53.3) =~ 48%, which was considerably lower than the 79% calculated on a book-value basis. So if we use the book values, in this case, we would get a lower WACC (assuming debt having a lower cost of capital than equity as is usually the case) which may lead to wrong capital budgeting, etc. decisions since actual WACC based on the real market values would be higher as market value of equity is much higher than the book value of equity.

So book values, especially for the equity part,  should not be used to evaluate the costs of capital.