Question

Why is it preferable to use market interest rates and equity values in calculating WACC instead of company financial data?

Answer 1

Company financial data is historical and reflects the cost of

capital when the funds were raised. The costs so calculated

will not reflect the current cost of the components of the

capital structure.

While calculating the interest rate payable on debt and the

dividend payable on preferred stock, one has to relate it to

the current market values.

Bond yields (before tax cost) are to be worked out based on

the current market price of the bonds, as market prices get

adjusted to changes in interest rates.

For preference shares, the dividend payable has to be related

to the current market price, as prices get adjusted to the

changes in the required rate of return.

As regards, common equity the expected stream of dividends

have to be related to the current price to get the cost of

common equity.

Once the cost of the components of total capital are worked

out, the weighting has to be based on market values. Only

then, the weighting will represent the current situation.