When calculating the weighted average cost of capital (WACC), the weights are based on:

• A. the book value of each component of capital
• B. the historical cost of each component of capital
• C. the market value of each component of capital
• D. the par value of each component of capital

Answer: (C)

Verified step by step guidance

1. Understand the concept of Weighted Average Cost of Capital (WACC): WACC represents the average rate of return a company is expected to pay its investors (debt holders and equity holders) for using their capital. It is calculated using the weights of each component of capital and their respective costs.
2. Recognize the importance of market value: The weights in WACC are based on the market value of each component of capital (equity, debt, etc.), not the book value, historical cost, or par value. This is because market value reflects the current valuation of the company's capital in the financial markets.
3. Identify the formula for WACC: The general formula for WACC is: \( \text{WACC} = \frac{E}{V} \cdot \text{Re} + \frac{D}{V} \cdot \text{Rd} \cdot (1 - \text{Tax Rate}) \), where \( E \) is the market value of equity, \( D \) is the market value of debt, \( V \) is the total market value of capital (\( E + D \)), \( \text{Re} \) is the cost of equity, and \( \text{Rd} \) is the cost of debt.
4. Explain why market value is used: Market value provides a more accurate representation of the company's current financial standing and the cost of raising capital. It adjusts for changes in investor perception and market conditions, which are not captured by book value, historical cost, or par value.
5. Apply the concept: When solving problems related to WACC, always use the market value of equity and debt to determine the weights. Ensure you have the correct values for \( \text{Re} \), \( \text{Rd} \), and the tax rate to complete the calculation.