Book Value and Market Value Weights
The second aspect of assigning weights to various sources of finance in calculating the composite cost of capital relates to the choice between hook value weights and market value weights. This problem will arise only in the case of historical weights.
Both these methods have their own merits. In theory, the use of market value weights for calculating the cost of capital is more appealing than the use of book value weights because: (i) market values of securities closely approximate the actual amount to be received from their sale; (ii) the costs of the specific sources of finance which constitute the capital structure of the firm are calculated using prevailing market prices. However, there are practical difficulties in its use as calculating the market value of securities may present difficulties, particularly the market values of retained earnings. Moreover, weights based on market values are likely to fluctuate widely.
On the other hands, the merits of book value weights are operational in nature. For one thing, book values are readily available from the published records of the firm. Also, firms set their capital structure targets in terms of book values rather than market values. Finally, the analysis of capital structure in terms of debt-equity ratio is based on book value.
In brief, the alternatives book values and market values of securities have their own commendable features, while the book value is operationally convenient, the market value basis is theoretically consistent and sound, and therefore a better indicator of a firm’s true capital structure.