Question

How should the capital structure weights used to calculate the WACC be determined? Imagine you are making this recommendation for a company. It needs to include, the recommendation, background about the recommendation, three reasons of rationale, risk analysis, and the next steps. These only need to be a few sentences each.

Answer 1

The capital structure weights to be used to calculate the WACC should be based on the market value of Debt, Market value of Equity and the market value of preference stock.

The market value approach is the best approach as it estimates the current or fair value of each component of the capital structure and based on these values, the weight in the capital structure is determined.

The reason behind choosing this approach is:-

1) The weights and hence WACC is based on realistic values of each component

2) Book value approximation is not accurate as that only reflects the cost basis of each capital structure component.

3) It leads to a more robust WACC estimation and hence better project appraisal.

Based on the available proportion of the various components of capital, the WACC is calculated as follows:

WACC = Debt % * Cost of Debt * (1- tax rate) + Equity % * Cost of Equity + Preference shares % * Cost of Preference Shares

It would be prudent to calculate each cost based on the most liquid security as that would truly reflect risk as well as return expectations of the market. Also, to ensure prudent risk management, the weights and proportions should be regularly updated to reflect current market conditions.