Which of the following statements is true regarding calculating weights for the Weighted Average Cost of Capital (WACC)?

• A. The weights are calculated using only the cost of equity.
• B. The weights are irrelevant as long as the costs of capital are accurate.
• C. The weights should always be based on the book values from the balance sheet.
• D. The weights should be based on the market values of debt and equity.

Answer: (D)

Verified step by step guidance

1. Understand the concept of Weighted Average Cost of Capital (WACC): WACC is the average rate of return a company is expected to pay its security holders to finance its assets. It combines the cost of equity and the cost of debt, weighted by their respective proportions in the company's capital structure.
2. Recognize the importance of weights in WACC calculation: The weights represent the proportion of debt and equity in the company's capital structure. These proportions are crucial because they determine how much influence each component (debt and equity) has on the overall cost of capital.
3. Clarify the basis for calculating weights: The weights should be based on the market values of debt and equity, not book values. Market values reflect the current value of the company's financing sources, which is more relevant for investment decisions than historical book values.
4. Explain why market values are preferred: Market values provide a more accurate representation of the company's financial position and the cost of capital. Book values, on the other hand, may be outdated and not reflect the true economic value of the company's debt and equity.
5. Summarize the correct approach: To calculate WACC, use the market values of debt and equity to determine their respective weights. Then, multiply these weights by the cost of debt and cost of equity, respectively, and sum the results to obtain the WACC.