When calculating the Weighted Average Cost of Capital (WACC), which valuation is preferable?

The Weighted Average Cost of Capital (WACC) reflects the average rate that a company is expected to pay to finance its assets, weighted by the proportion of each finance source within the total capital structure. Using the fair market value of debt and equity is preferable for several reasons.

Firstly, fair market values provide a current assessment of how much the market believes the company’s debt and equity are worth at that moment. This reflects the risks and returns required by investors today, which can differ significantly from historical costs or book values. Utilizing fair market value ensures that the WACC is based on up-to-date and relevant information, which is essential for accurate financial analysis and decision-making.

Additionally, market values take into account the prevailing interest rates and market conditions that affect equity and debt costs. This is particularly important in a fluctuating financial environment, where the cost of capital can vary over time due to changes in investor expectations, risk premiums, and economic conditions. In contrast, historical costs do not capture these dynamics and can lead to outdated or misleading conclusions about the company's capital costs.

By calculating WACC using fair market values, firms can better evaluate investment opportunities, make informed strategic decisions, and ultimately align their financing strategies with current market conditions.