Question

Difference between Book Value and Market Value in WACC analysis? And which one is higher when company heavily financed on debt?

Answer 1

Book value means the value of business according to it's books of accounts that is reflected through financial statements. Book value indicates total Worth of a company if all assets are sold and all the liabilities are paid.

Book value of a company = Total assets - Total liabilities

Market value represents the value of a company according to stock market. While market value is a generic term that represents the price an asset would get in the marketplace, it represents the market capitalization in the context of companies.

Market capital of a company = Current market price (per share)∗ Total number of outstanding shares.

Book value vs market value:

Weighted Average Cost of Capital (WACC) is defined as the weighted average of cost of each component of capital (equity, debt, preference shares etc) where the weights used are target capital structure weights expressed in terms of market values. We will discuss the difference between book value WACC and market value weights and why market value weights are preferred over book value weights. It is assumed that the primary purpose of WACC is to evaluate new projects.

Different types of weights:

The weights can be historical or marginal and further historical weights can have either book values or market values of capital components.

The book value weights are readily available from balance sheet for all types of firms and are very simple to calculate. On the other hand, for Market Value weights, the market values have to be determined and it is a real difficult task to acquire accurate data for the same especially the value of equity when the entity is not listed. Still Market Value WACC is considered appropriate by analysts because an investor would demand market required rate of return on the market value of the capital and not the book value of the capital.

Book value will be higher when heavily financed bebt.